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Copyright © 2012 by K&L Gates LLP. All rights reserved.
Startups 101
Chung-Tung University Alumni Association – NCTaiwanese American Industrial Technology Association
June 19, 2012
Fred Greguras, K&L Gates LLP(650) [email protected]
Charles Holland, K&L Gates [email protected]
1
K&L Gates Law Practice We have offices in major cities around the U.S.
and across the globe, including 6 offices and 100 lawyers in Asia We advise start-up and established technology,
renewable energy and other types of businesses
We work with global and U.S. venture capitalists and private equity investors
Cross border M&A and IPO exits in the U.S., Hong Kong, Taipei and AIM in London
Mandarin and Cantonese speaking attorneys throughout the firm
3
Overview
Making a clean break from a prior employer Choice of legal entity Why, when and where to incorporate Conventional capital structure Founders shares allocation and vesting Stock option plans China and offshore corporations
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Making a Clean Break underCalifornia Labor Code 2870
“Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall NOT apply to an invention that the employee developed entirely on his or her owntime without using the employer’s equipment, supplies, facilities, or trade secret information EXCEPT for those inventions that either:
1. Relate at the time of conception or reduction to practice of theinvention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or
2. Result from any work performed by the employee for the employer.”
5
What Are The Implications? “Clean break” will be tested in due diligence in a financing -
employee has burden of proof “Relate” to the employers business will be construed broadly
according to court decisions - covers employer’s scope of business not just employee’s job scope
No time limit on the prohibition on using the employer’s trade secrets
Working completely outside an employer’s premises and not using an employer’s resources is not enough to avoid a taint
Overlapping employment (“moonlighting”) by a founder Use of consultant – who does he/she work for? Does not apply to general skills or knowledge but where is the
dividing line Conception is not just thinking about a problem needing a solution
but is the new product based on a generally known market need oran undisclosed vulnerability in the employer’s product?
6
Avoid Doing the Following(Assuming Same Business Space)
Any overlap in employment Filing a provisional (or utility) patent application a few days
after you leave your old company Assigning IP and technology to purchase your shares in the
new company Reducing any ideas about a possible invention to any
tangible medium while at your prior company Developing the product in the new company at “super
human” speed Taking anything from your prior employer even paper clips
7
Choice of Legal EntityLimited Liability Company (LLC)
Used for consulting and other small businesses One or more owners (members) Formalities of a corporation are not required Members generally not personally liable for
obligations of the business (unless guaranteed) Can elect to be treated as a corporation or
partnership for tax purposes Regulatory filing is required to establish an LLC
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Choice of Legal EntityC-Corporation
State corporation – C tax status is the default if no S corporation election
One or more owners (shareholders) Management by a board of directors elected by
shareholders; officers elected by the board Shareholders not personally liable for obligations of the
business (unless guaranteed) if formalities followed A tax return is required at the corporate level,
corporation pays the taxes Regulatory filing is required to establish a corporation
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Why and When to Incorporate Most start-ups seeking investment incorporate
Investor requirement and comfort Enables use of stock options for service providers Corporation can be acquired tax-free with stock
(LLC cannot) Corporations are the best vehicle for going public
Incorporation requires more than filing articles of incorporation No one owns the corporation unless shares are purchased
When to incorporate? Document founders ownership Take actions that could create personal liability Sign a customer contract or even a NDA Grant stock options to “pay” for development services Receive investment – particularly one in which the company will be valued Need to hire employees
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Where to Incorporate California, Delaware, Cayman Islands, elsewhere
Geographical market focus Investor comfort or requirement Flexibility in exit strategy
Cannot avoid California taxes if the corporation is operating in California Delaware advantages are investor preference, ease of dealing with
regulatory authorities, flexibility in the law (such as number of board members), more precedent on corporate law. Disadvantages are being taxed by and subject to two states requirements.
California advantages are lower cost and being subject to only one state’s requirements, if operating here. Major disadvantage is difficulty of dealing with regulatory authorities.
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“Nuts and Bolts” of Incorporating
File Articles of Incorporation Incorporator resigns and appoints initial board of
directors Organizational consent of the board in which:
By-laws adopted Founders stock purchases approved Equity incentive plan approved Initial stock option grants approved
Founders buy shares under the stock purchase agreements
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Conventional Capital Structure Keep it simple and conventional “1X” pattern
Fully diluted concept: outstanding shares + outstanding options + option reserve
OutstandingAuthorized or Reserved
______________________________________________Common Stock 10M 3-5M Founders
1-2M Stock Option Plan
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Capitalization Example
● Founders 4M
● Stock Option Plan 1M
All Common Stock Outstanding Reserved
Fully-diluted is 5M shares (4M +1M) Founders own 100% of the company on an outstanding share basis 4M/4M) Founders own 80% of the company on a fully-diluted basis (4M/5M) Investors will calculate their ownership on a fully-diluted basis
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Financing Valuation CalculationExample
$4M pre-money valuation, $2M investment in Series A Fully-diluted pre-money is 5M shares of common stock 4M shares of common stock issued to founders
1M shares of common stock reserved in stock option plan. SeriesA price is $4M/5M (fully-diluted) = $0.80 per share. $2M buys 2.5M Series A shares
Resulting cap table is:
100%7.5 M33.33%2.5 MInvestors13.33%1MPlan53.33%4MFounders
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Founders’ Shares Allocation and Purchase
3-5M shares of common stock Buy common stock at a nominal price
Timing of purchase – avoid being near the Series A financing for tax reasons
Payment is by cash, assignment of technology or other property. Need to purchase shares in order to own the corporation. Company must own its technology and intellectual property
but avoid 2870 taint Transfer all property at the same time under IRC § 351 – not
applicable offshore
16
Founders Vesting Issues
What is stock vesting? Company right to repurchase shares on termination,
at original purchase price, that lapses over time Right is exercisable if founder stops providing
services to the company 83(b) filing/consequences – within 30 days after
purchase Why impose vesting pre-financing? Provides incentive for founder to continue to provide
services to the company Avoids “free-rider” problem if a founder leaves
17
Founders Vesting Issues
How much vesting up front for founders? Work done in past Value of intellectual property/other contributions Stickiness – most important factor
Time vesting 3 or 4 years Cliff, no cliff Monthly, quarterly, annually after a cliff
(monthly after the cliff is more common)
18
Founders Vesting Issues
Vesting acceleration for founders – set up at founding in founders stock purchase agreements Trigger events
Upon termination without “cause” or for “good reason”(outside of an acquisition)
Acquisition of the company with “double trigger” on acquisition – stickiness
What is a “double trigger”? Trigger One - Company acquired Trigger Two – Termination within 12 months
(or other period)
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Stock Option Plans
Create and approve at time of incorporation so “currency” is available to attract and retain employees and other service providers
Option plan provisions and filings must comply with federal and state securities and tax laws
Difference between ISOs and NQSOs – when income must be recognized
Eligibility for each type of option Employee: ISO or NQSO Other service provider: NQSO only
Acquisition consequences in plan - stickiness Fair market value pricing for 409A purposes
20
China and Offshore Corporations Test the waters for the business before building infrastructure
Start with U.S. or other domestic company? Local government investment is causing more startups to be China
domestic companies In general, reincorporating a company offshore is treated as a sale of the
company unless the transaction is a bona fide acquisition. Under IRS 7874, the tax consequences of reincorporation offshore is
either a sale of the company or the new company remains a U.S. corporation for tax purposes. Sale with no cash if former shareholders own 60-80% of new foreign
company Treated as U.S. corporation if former shareholders own 80%+ of new
foreign company China government approval (Ministry of Commerce) is required for
reincorporation.
21
Exit Strategy Formation Considerations (I) Geographical market focus
China or global Nature of founders/investors
Domestic, foreign or both
Local government funding Global investor preference or requirement
China or offshore Restricted or prohibited industry status under Chinese law Media, telecom, internet,…**Catalogue of Industries for Guiding Foreign Investment (2011 Amendment)
22
Exit Strategy Formation Considerations (II)
Foreign exchange restrictions on moving money out of China
Listing eligibility on stock exchanges Exit alternatives are restricted by where the company
is formed particularly if in China M&A rules in China, US and elsewhere (MOFCOM,
SAFE, etc.) restrict availability of suitors
China Securities Regulatory Commission (CSRC) approval required for domestic and offshore IPOs
Copyright © 2012 by K&L Gates LLP. All rights reserved.
Key Intellectual Property Issues for Startups______________________________________
June 19, 2012
Chuck Holland and Fred Greguras, Esq.K&L Gates LLP
(650) 798-6710 and (650) 798-6708
24
Key Points
Get intellectual property into the company early Granted patents and trademarks
Get the intellectual property basics right –investors, acquirers, underwriters will carefully investigate
25
Overview ofKey Intellectual Property Issues for Startups
Scope of intellectual property associated with your business
Ownership of rights to that intellectual property
Freedom of operation
Routine practices to further each of these
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Scope of IP – background info on types of intellectual property a company develops
Patents (utility, design, utility model) - inventions
Trade secrets and know-how – info. you developed
Trademarks/service marks/domain names
Copyrights
27
Scope of IP – background info on some rights each type of IP provides
Patent – right to exclude others from making, using, selling, offering, importing what is claimed in the patent; expires 20 years from earliest priority claimed
Trade secret/know-how – right to stop others from using confidential information taken from you; available as long as you keep information confid’l
Trademark/service mark/domain name – right to stop others from using identifiers for your company in a confusing way; valid as long as you are using it
Copyright – various rights to stop others from using or reproducing an original work; lasts at least 70 years
28
Scope of IP – background info on rights each type of IP does not provide
Patent – does not provide the right to freely make, use, sell, offer for sale, import what is claimed
Trade secret/know-how – does not provide the right to stop others from reverse-engineering or independently developing or learning information
Trademark/service mark/domain name – does not provide the right to stop others from using same or similar mark or namefor business in different business line
Copyright – does not stop someone from using the idea conveyed by your copyrighted info; only stops someone from using your expression of that idea
29
Scope of IP – patents Decide whether trade secret or patent protection is appropriate
How easily can technology be reverse engineered?
Assess whether to file provisional or non-provisional application
How much development in next year
Exit strategy – patents matter more than applications; provisional app’s are not examined
30
Scope of IP – patents (cont.)
Budget
Foreign filings are expensive – assess where patents are essential (key markets, manufacturing) and build into budget
Application drafting costs are the tip of the iceberg when compared with foreign costs Know the prior art to maximize claim scope Provisional applications misconception
Often little disclosure to keep cost low but may not meet statutory requirements or you may think you have more protection than you actually have
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Scope of IP – patents (cont.) Budget (cont.)
Cleaning up poorly-strategized portfolios can be expensive and rights can already be compromised
32
Scope of IP – patents (cont.) Timing
US patent first Office Action roughly 2 years after filing non-provisional application, lucky to have patent grant in 3 years
Procedures to accelerate U.S. examination Prioritized examination - $4800 surcharge large entity
Petition to make special
Procedures to accelerate foreign examination Patent prosecution highway
PACE in Europe
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Scope of IP – patents (cont.) Develop and implement IP strategy in view of exit strategy
Claim scope in view of prior art
Draft applications and claims knowing the countries where applications will be filed
Decide on whether to file multiple applications in certain countries for same invention
Narrow v. broad patent claims
Different “inventions” under that country’s law
34
Ownership of patent – common issues
University technology
Previous employer
Contractor or other outside contributor
Joint ownership and licensing implications
Employment agreement wording for employees
Resolve issues early – easier and less costly to fix problems
35
Freedom of Operation – patents
Others have patent claims that you infringe in country in which you want to operate Potential defensive positions Opinions that claims are invalid or not infringed Procedures to invalidate granted claims Procedures to cite prior art during prosecution
Investment still possible despite potential freedom of operation issues Well reasoned positions Likelihood of designing around or product evolving
36
Freedom of operation – patents (cont.)
Budget Search and analysis of patents and applications Comprehensive search and review is typically
expensive because you are analyzing many aspects of a product
Timing – well before diligence When to obtain freedom of operation analysis
depends on stage of product development Analyses may take a long time if many patents
and patent applications need to be reviewed
37
What is a Trade Secret?
A trade secret is something that:
Derives economic value from not being generally known
The company takes reasonable steps to keep secret
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What is a Trade Secret? (con’t.)
Examples of possible trade secrets: Computer code “Know-how” “Negative know-how” Future production information New products Pricing
Combinations of “publicly available elements” Certain customer information
39
What is Not a Trade Secret?
Examples: Publicly available/disclosed information Information available on the internet
Information disclosed to third parties without a non-disclosure agreement
Industry conventions Employee’s general skill, talent, experience
40
Protect company from allegations of trade secret theft Instruct new hires: Don’t bring prior employer’s trade
secrets with you! Prevent new employee from:
Performing duties that would involve use or disclosure of prior employers’ trade secrets
Bringing documents/computer files that belong to prior employer
Employment agreement and policies
41
Scope and ownership of trade secrets
Comprehensive trade secret program Take measures to limit access to confidential info
to those who need to know in company Keeping records of trade secrets Locking trade secrets
Employment agreements and policiesNo disclosure to those outside the company Nondisclosure agreements Raising capital Diligence
42
Scope of IP – trade secrets
Discuss trade secret policy on hiring and on employee departureHave records to show your trade secret program for diligence - document these discussions and agreementsEnforce theft or breach to limit losses Ex-employees Breach of nondisclosure agreement
43
Do Your Homework on Your Company Trade Name, Trademark and Domain Name
First visible aspects of your business and first legal exposure
Coordinate all types of protection – trademark, trade name, domain name
Trademark is the strongest protection Don’t go to your attorney the day before you
release your product Do the search and mark analysis in relevant
countries Often less expensive and timely to switch to
another name or mark than fight at startup time
44
Mark Your Intellectual Property With Proprietary Notices
Credibility indicator
©, ®, ™, etc.
Confidentiality notices
Patent pending
45
ProgramsPatents:1.Identify and document inventions2.Prioritize inventions (old and new) to
Pursue some in various countries Sell or drop old ones of no value
3.Searches to identify prior art and potential freedom of operation issues (especially competitors’ patent filings)4.Match prosecution strategy to business (exit) strategy
46
ProgramsPatents (cont):5.Agreements assigning rights to inventions (founders, employees, contractors)6.Identify opportunities to license7.Stop infringers to protect market share
47
Programs (cont.)
Trade secrets:1.Employment agreements and policies2.Discussions with employees on hiring and on separating confirming employee does not use trade secrets of others for company business and does not use or disclose company trade secrets3.Procedures and systems to limit access to and use of trade secrets4.Stop unauthorized use or disclosure
48
Programs (cont.)
Trademarks and service marks:1.Search relevant countries for registrations2.Register marks in relevant countries to assure your use of marks3.Oppose issuance of confusingly similar marks4.Police unauthorized use or confusingly similar marks and stop infringers
50
Comparison of Patent, Copyright andTrade Secret Protection
Copyright Patent Trade SecretScope Narrow-images, form of
expression onlyBroad Broad if kept confidential
When does protection begin
Work is fixed in tangible medium of expression
Issuance of patent Work is created in a confidential matter
Duration of protection Generally life of author plus 70 years
20 years from filing Indefinite if kept confidential
Source of protection Work is fixed in a tangible medium of expression Enforceable upon registration with USCO
Issuance of patent by USPTO. Invention must be “useful, new and nonobvious”
Contract or trust relationship which maintains confidentiality
Cost to implement Minimal Expensive$5K-20K per application
Minimal
Time to implement Immediate but need to register with USCO to enforce
2-3 years Immediate but always need to protect secrecy
Strength of protection Weak Strong Strong
51
Comparison of Patent, Copyright andTrade Secret Protection (con’t.)
Copyright Patent Trade Secret
Employer/Employee work ownership protection
Yes Get assignment of ownership
Get assignment of ownership
Corporation/Consultant work ownership protection
Need assignment of ownership
Need assignment of ownership
Need assignment of ownership
Mass market product distribution protection
Yes (statutory) Yes (statutory) No (contract)
Independent product development defense
Yes No Yes
Global protection Easy to implement Needs issuance in each country
Easy to implementin limited distribution
Infringing/ misappropriating acts
Copying, preparing derivative work, distribution, display of the work
Making, using or selling the invention claimed in the patent
Use or disclosure of the trade secret
How can I damage my own rights
Notice not required on work to protect but registration with USCO is required to enforce
Public disclosure or offer for sale more than 12 months before the application was filed
Disclosure of the trade secret