by Tom Taulli
In this chapter, we take a look at the legal blunders Zuckerberg made during his company’s infancy, as well as several strategies he could have used to avoid the many infamous legal headaches that Facebook has suffered. As you’re reading, soak up the legal lessons of this chapter and learn from Zuckerberg and Facebook’s mistakes, because nothing can bring a young company to its knees faster than a lawsuit (or 12). Just look at Napster.
Obtain Legal Services
When starting a new venture, it’s tempting to scrimp on legal fees. Why should anyone get hundreds of dollars per hour for their services? Aren’t the majority of legal issues that startups face fairly straightforward?
Not really. The law is critically important in any business endeavor, and the legal details of even the most everyday business transactions can get extremely complicated. Despite this well-known reality, many entrepreneurs still try to go solo when it comes to their legal issues, and they rely on a free Google search rather than a paid legal professional. They also try to find sample contracts online and then attempt to tailor them to their business’s needs. Obviously, this inadvisable practice can cause a world of trouble for young startups, because these legal documents may have already been negotiated or may be aligned with the laws of a jurisdiction other than that in which they operate.
Some founders, acquiescing to the necessity of obtaining some form of legal advice for their company, use third-party legal services like LegalZoom. Although companies like LegalZoom provide tremendous services at cost-efficient prices, they are often incapable of meeting adequately the needs of a technical startup with specialized issues that include the need to protect intellectual property. In addition, the fact that online legal services are named as such is a bit misleading, because they do not provide actual legal services. More accurately, they are document preparation services—and very good ones, at that—but you should not rely on them to serve as your company’s legal counsel.
No doubt, your best solution is to hire a qualified attorney who specializes in technical startups to advise your company in the many legal challenges it will undoubtedly face. Startup attorneys not only understand the nuances and landmines that are part and parcel of building a new venture, but they also realize that startups have little capital to spare. As a result, technical startup attorneys are usually willing to take equity as payment for their legal fees during a startup’s early days. Facebook, for example, issued 1.29% in equity to its first law firm.
Aside from sparing you the need to fork over huge amounts of cash in your company’s infancy, paying your attorney in equity effectively aligns their interests with those of your company. In other words, your attorney wants to see her equity in your company expand, effectively leading her to provide you with better legal counsel, which is a win–win for all involved. Also, most likely, you won’t be your technical startup attorney’s first client, which means that she probably has lots of contacts in the technology startup industry and might even be willing to make key introductions to potential investors.
Prior to hiring an attorney, make sure you perform some due diligence on your candidate pool. First, get a list of each candidate’s clients—either from fellow entrepreneurs or services like Avvo—and call them. Doing so is a good way to get a better sense of the caliber of the attorneys. Here are some other suggestions:
Make sure you negotiate the attorney’s fees, and never take the first offer that she makes. This type of negotiation is actually expected and even customary.
Insist that a partner work on your account, not a junior associate. Although you’ll pay a higher rate for the counsel of a partner, the quality of the work will be much better.
Put a cap on admissible attorney’s fees. Why give a lawyer an excuse to keep billing and billing?
Remember that attorneys are naturally conservative and have a tendency to focus on all the ways in which you and your company could get into legal trouble. So, when your attorney gives you legal advice, make sure you ask questions such as “What are the chances of getting in trouble?” and “What would be the consequences?” If the potential fallout seems minor or worth the risk, then you should purse that course of action even if an attorney has some doubts about it. Business is about taking calculated risks.
Now let’s take a look at Zuckerberg’s experience with obtaining legal counsel. Although Zuckerberg’s contract programming work was certainly helpful to him and Facebook, because it enabled him to build his business savvy and learn his craft, one of his contract projects turned into a legal nightmare for the company. In November 2003, twin brothers Cameron and Tyler Winklevoss as well as Divya Narendra met with Zuckerberg to develop a web site called HarvardConnection, which would host a list of upcoming parties and provide discounts for nightclubs. The Winklevosses and Narendra agreed to let Zuckerberg in on the deal. There was no written contract between the four parties, but there were many e-mail and instant messages that indicated that they had arrived at some type of agreement—part of which was, in exchange for equity in the enterprise, Zuckerberg would create the web site for HarvardConnection.
Zuckerberg was immediately given access to HarvardConnection’s server. However, despite stating initially that the job would be an easy one to complete, he failed to make much appreciable headway on the project. He claimed that he was swamped with schoolwork, but assured the Winklevosses and Narendra that he was working steadily on the site. Meanwhile, without ever having created functional code for HarvardConnection, Zuckerberg registered the domain name thefacebook.com and launched his own social networking site, which later became the phenomenon we all know today as Facebook. Upon hearing of Zuckerberg’s web site, the Winklevosses and Narendra quickly filed a lawsuit, claiming that Zuckerberg stole their idea for a social network (they eventually created a college site called ConnectU). The litigation was finally settled in early 2008 for an estimated $65 million.
This experience was a classic, expensive mess, and Zuckerberg could have avoided this legal headache by taking a few simple precautions. First of all, after agreeing to work with the Winklevosses and Narendra on their web site, he could have insisted on a written contract and asked an attorney to review it prior to signing it. When becoming a partner in a new venture, it is essential that you sign a document that outlines each partner’s rights and responsibilities. Prior contract work and former jobs are often sources of problems for entrepreneurs who start new ventures, so think hard about your legal exposure—and about what papers you should or should not sign. Here’s some advice:
Nondisclosure Agreement (NDA): Under the terms of an NDA, you cannot disclose material information to third parties—in general, for a fixed period of time, say, a year or two. These contracts can be broad but are usually enforceable. If you have signed an NDA and then start a company that is similar to your employer’s or your client’s, then the NDA could be a problem. Even if there is not an NDA in effect, the employer or client may be able to claim misappropriation of trade secrets. As a general rule, then, be wary about using propriety information when creating your own venture. Doing so could result in a nasty lawsuit.
Noncompete: Under the terms of a noncompete agreement, you cannot compete against your employer or client for a set period of time—often a couple years. The good news is that noncompete agreements are generally not enforceable in California, but this is not the case with many other states. It’s yet another reason to create a company in California. Keep in mind, though, that if you signed a noncompete agreement as part of an acquisition, you may be held accountable if you do not abide by its terms. After all, you likely received payment for your efforts.
Work-for-Hire: Typically found as a clause in a contractor’s agreement, a work-for-hire forces you to relinquish your right to the intellectual property to any work or product that you create for a client. Work-for-hires could cause you huge problems if you go on to form your own business based on work you completed for somebody else. Thus, if you plan to do contract work, it is prob
ably best to avoid doing so in an area on which you plan to focus when you start your own venture. If you’re an employee at a company, you will probably be asked to sign an invention assignment. Like work-for-hires, invention assignments give full ownership to your employer to all the intellectual property you create on the job. Some companies may even extend the time period in which this type of agreement is in effect beyond your last day of employment, such as for 6 months to 1 year. California, however, has some wiggle room. For example, if you create an invention during off hours, do not use company resources to invent it, and it is not relevant to your company’s business, then the employer has no ownership rights to it. An invention agreement may require that you disclose your activities, though.
Nonsolicitation: This type of agreement states that you are not allowed to poach the customers or suppliers of your employer. Interestingly enough, California looks unfavorably on these types of arrangements. Leaving an employer to form a startup is typical in Silicon Valley. In other words, even if you sign and ignore a nonsolicitation agreement in California, your former employer may not subject you to any litigation. In some cases, entrepreneurs may even get an investment from their original employer or may put together a customer or partnership arrangement. However, you should still be cautious when signing this type of agreement.
Stock Options: If you work for a high-tech company, then make sure you understand your rights regarding your stock options when you leave the company. A stock options agreement usually permits you 90 days to exercise your vested options, but the sooner you do this, the better.
Consider Incorporation
When should you incorporate? There are no magical answers to this question, and it seems—at least when it comes to legal matters—that this is typically the case. Here are some common triggers to consider incorporation:
Hiring employees or contractors
Talking to potential customers
Talking to potential investors
Securing a cofounder or two
These four triggers are all serious steps in creating a company, and it is much easier to pursue these efforts under the guise of a corporation. If nothing else, being incorporated lends you more credibility when talking to potential employees and investors, because they’ll know you have a certain level of commitment to the venture.
Here are some benefits of being incorporated:
A corporation is critical when hiring noncitizens or nonresidents, because obtaining a visa is easier for these individuals if the business for which they are working is incorporated. In addition, international talent has become vitally important for technical startups.
A corporation makes it easier to issue stock options, which is critical for technical startups.
A corporation provides liability protection and ensures that the investors and officers are not held personally responsible for any debts or claims made against the corporation. Keep in mind, though, that you are not protected if you fail to maintain the formalities of the corporation, such as conducting board meetings and publishing an annual report.
If you incorporate your company earlier in its life span, you may also be required to pay less taxes if and when it comes time to sell. How is this so? Consider that if you own stock for more than 1 year before selling it, any gains you accrue on the sale are subject to a maximum federal taxation rate of 15% (not including any taxes levied by your state). If you do not hold the stock for at least a year, then you pay taxes at the ordinary rates, the maximum of which is 35%. For example, suppose you incorporate your business on January 1, 2012, and then launch your product in November 2012. Then, in February 2013, you decide to sell your company for $2 million. In this situation, you would get taxed at 15% because your shares in the company are more than 12 months old. It’s true that it may cost several thousand dollars to incorporate, and there are always ongoing expenses and filings involved with incorporating. However, when it comes to your venture, incorporation is a smart move—a move that, in the end, could save you potentially millions of dollars.
Each state has its own corporate laws and has a variety of structures, such as a C-Corp, a Limited Liability Company (LLC), and an S-Corp. The differences among them may seem arcane, but often have to do with taxes and the need to conform to certain business formalities, like conducting board meetings, as mentioned earlier. For example, LLCs have minimal filing and administrative requirements, which result in lower taxes for the company. Perhaps this is why Facebook’s co-founder Eduardo Saverin originally formed Facebook as an LLC.
Unfortunately for Saverin, whose main role at the company was to help with business matters, this was a wrong decision. If he had thought far enough into the future, he might have been able to guess that Facebook would eventually need to raise outside capital, which means establishing Facebook as a C-Corp, preferably one in Delaware. Delaware C-Corps don’t just make it easier to obtain financing; they also are streamlined for setting up option plans, which allow a company to provide equity compensation to employees. Furthermore, the state of Delaware is home to many corporations specifically because it has a well-developed set of corporate laws, and the judges in that state also tend to act quickly on legal matters.
While some attorneys may quibble, I think a Delaware C-Corp is the best option for technology startups.
When forming one, the following are some things to consider:
Establish each partner’s roles and responsibilities within the corporation. Here, again, is an opportunity to learn from Facebook’s mistakes. Saverin maintained control of the LLC, and when he had a dispute with Zuckerberg, he actually froze the corporation’s bank account. This heedless action almost killed Facebook, and Zuckerberg and his father had to put up $85,000 of their own capital to keep it afloat.
Maintain control of your stock. Just look what happened to Craigslist. In 2004, one of Craigslist’s employees sold a 28.5% stake in the company to eBay, which turned out to be a terrible situation for Craigslist, because eBay eventually came out with its own classified service. Craigslist would never have been in this mess, however, if it had set stock resale restrictions. If Craigslist had given itself the right of first refusal—or, in other words, the option to buy shares of its own stock at the same price and terms that a third party is willing to pay—it could have avoided this horrible situation altogether.
Assign all the intellectual property to the corporation. If you don’t, the entity has little value and investors may not be willing to make any commitments to it. Furthermore, if you have a cofounder and fail to assign all the corporation’s intellectual property to the entity itself, the cofounder could very well take her intellectual property and go elsewhere with it. Consider that when Facebook was created, Zuckerberg did not assign the intellectual property to the LLC. As a result, the entity had little value, except for some money in a bank account.
Determine How to Split Equity Before the Need Arises
When forming a company, the founders are often optimistic and friendly—and with due cause. Hey, it’s an exciting time—full of huge amounts of potential. However, all this shared excitement can cloud your judgment. As much as possible, you need to realize that, over time, there are bound to be disputes between you and your cofounder. This very scenario cropped up fairly quickly in the case of Facebook, given Zuckerberg’s early clashes with Saverin. In some cases, these disputes can result in either you or your cofounder leaving the company. In light of this, you need to think about protecting your interests, which means negotiating hard with your co-founders. A key issue is making sure you allocate the equity in a way that motivates your team but is not too generous that it risks harming the venture.
The nonconfrontational approach to this issue is to split everything equally, but this may be the wrong way. For example, suppose one founder has quit his job to dedicate himself fully to the venture whereas the other founder is still working a nine-to-five job and can only commit time to the company after hours and on weekends. In this case, it wo
uld not be fair for the founders to split the equity evenly. Or suppose one founder is bringing existing code or customers or cash to the table. Would it make sense in this situation for each founder to be compensated equally? Probably not.
Equity-sharing discussions can be uncomfortable—and even contentious—but they may provide some insight into the real personalities of your cofounders. You may even realize that they may not be a good fit! As for Facebook, there was a difference in the equity split, with Zuckerberg getting a 65% share, Saverin getting a 30% share, and Dustin Moskovitz (who became involved in Facebook later in its development but is still considered one of its original cofounders) receiving a 5% share in the company.
Use Vested Founders’ Stock
Suppose you start a business with three other cofounders. Everyone works extremely hard, except one person: George. He rarely does any coding and when he does get involved, he usually complains. He’s actually become a liability to the venture. You and your other cofounders want to push him out of the company. The problem is that he owns 25% of the company’s stock. In other words, he is, essentially, getting a free ride based on the efforts of everyone else. It’s unfair, right? Absolutely. However, fairness in this case does not matter to a judge. George paid for his stock and in return received 25% ownership. It’s that simple.
However, there is one way to deal with this type of situation—by using vested founders’ stock. Here’s how it works: Suppose your company has 1 million shares, and you and your other three cofounders have decided that each founder receives 250,000 of those shares. The price per share is 1¢, so each founder pays $2,500 to capitalize the venture. Then, in your company’s shareholder agreement, you include a vesting schedule that stipulates that a founder has to wait at least 1 year to vest—or obtain ownership—of the first 62,500 shares of his investment. The rest of his shares will vest, each month, for 3 more years.