Capital Region Business Journal

Basic principles are important: A sound business plan, a true understanding of market demand and the competition, and a quality management team. In addition, technology companies need to make sure legal mistakes don't doom the enterprise when the founders' and friends' money runs out and third-party equity is needed.

1. Selling securities to unaccredited investors. Most startup companies raising capital from private investors rely on securities exemptions such as Regulation D to the Securities Act of 1933. Regulation D has very specific disclosure requirements if the investors are "unaccredited." Such disclosures can be extensive and are similar to those required when a public stock offering is made. Technical violations of these requirements may complicate obtaining regulatory clearance from the Securities and Exchange Commission (SEC) if the company eventually proceeds to an Initial Public Offering (IPO). The best course is to avoid selling stock to "unaccredited investors" and to obtain written confirmation through a questionnaire that the investors are accredited.

2. Granting stock to employees without adopting a proper stock-option plan. In the rush to attract talent, companies often make promises to employees concerning stock options without fully considering the effects of such promises on subsequent funding rounds through venture capital or IPO.

Companies also often fail to consider the tax consequences to the employee. A qualified incentive stock-option plan under Sections 421 and 422 of the IRS Code can avert unnecessary taxation by allowing an employee to postpone recognition of income until the time the employee actually sells the stock. As a result, the employee does not have to find cash to pay taxes on the value of the options granted. In addition, if the employee holds the stock for a certain time, any gain will be taxed as a capital gain rather than ordinary income.

3. Offering stock to employees at below-market rates. Promising options at a below-market price to employees can cause the SEC to find a "cheap stock" problem in a subsequent IPO. The problem arises when a company grants options at a price below market value. The SEC could, at the time of an IPO, determine that the company has not charged the proper value of the stock options against its earnings and require an earnings restatement to properly reflect the higher compensation and, of course, lower company earnings. This can be avoided by documenting the basis for stock valuation at the time the option is granted. Third-party appraisal is probably the best way to obtain this evidence. In any case, a clear articulation of the reason for any significant difference between the price of the employee stock or option grant and the IPO price is essential.

4. Failing to secure proper title to intellectual property (IP). Tech companies are built around IP, yet companies are often unaware that specific legal steps are required to ensure that the company owns the IP that its entire existence depends upon. The confusion comes from the fact that inventors (under patent law) and authors (under copyright law) are individuals, not companies. Certain written documents are required to move ownership from an individual to the company.

For example, under patent law the patent rights in the first instance belong to the employee or contractor who conceives and develops the invention. These rights must be assigned in writing to the company, and such assignment must be supported by consideration (payment or benefit of some kind to the employee or contractor).

Under the copyright act, when employees author copyrightable works in the course of their employment, the employer is deemed the author. However, this is not the case with independent contractors. A written "work for hire" agreement, or in some cases an assignment, needs to be entered into to be sure that the company owns the intellectual property.

It can be quite costly to clear the title to the IP after the fact, especially when, as a result of new equity coming in or an IPO, the creators or inventors might expect a payment that is substantially more than they would have accepted if the transfers had been obtained at the time of creation or invention. Employees involved in invention or authorship should be asked to sign nondisclosure and inventions agreements at the commencement of their employment to be sure that ownership issues are clear.

5. Failing to obtain a comprehensive trademark search before adopting company and product brands. Many companies select a name for their business or products before checking to see if the name is in use by another company selling identical or related goods and services. Words, names, symbols or designs that serve to distinguish one company's products or services from another's are protectable trademarks. Rights to certain trademarks arise through use, so a federal registration is not required to have trademark rights. However, the remedies and ability to enforce trademark rights are greater if the company has a federal registration.

The owner of a trademark can keep others from using a trademark that is likely to confuse consumers. A company that has invested in marketing and promotion without obtaining trademark clearance can be liable for trademark infringement. While most infringement claims can be resolved without a trademark lawsuit, substantial costs may be incurred in connection with changing the brand, pulling the infringing products or marketing materials from the market, and potentially paying a settlement demand or legal fees.

Company leaders often are under the impression that because a domain name containing the desired trademark was available, the mark is clear. However, this is not always the case. There could still be a federal trademark registration or common-law use that would preclude use of the trademark. It is also not enough to simply check the Patent and Trademark Office database of registered trademarks, since common-law rights can exist even without a federal registration. Conducting a complete search of federal and state registries, as well as sources of common-law use, such as industry directories and the Internet, is the best way to reduce the risk of having to discontinue use of a brand and incur substantial sums to resolve the matter.

6. Failing to make an informed decision on whether you should seek patent protection or rely on a trade-secret protection program to protect inventions. Certain inventions may either be patented or protected as a trade secret, but not both. There are pros and cons to each type of protection, and which one is right depends on a number of factors. Many companies think about patent protection but overlook trade-secret protection. The essential element of a trade secret is secrecy; thus, if someone can easily reproduce or reverse-engineer the invention, then you probably want to seek patent protection. With patents, on the other hand, you must publicly disclose the invention and the best mode of practicing the invention. Although you can stop others from producing or marketing your invention, the cost of enforcement is significant. Unless the company has obtained patents in other countries, you can only stop infringement inside the United States. Thoughtful selection of the type of protection that is appropriate in your specific circumstance will ensure that your investment in securing a patent or implementing an effective trade-secret protection program is not lost.

7. Seeking patent protection too late. U.S. law generally provides that a patent must be filed no later than one year from the time of a public use or offer for sale. Often an inventor's excitement about his or her invention leads to disclosures that start that clock ticking, and companies formed to commercialize the invention sometimes find that the opportunity for patent protection has been lost. Most foreign countries do not provide a one-year grace period, as they require absolute novelty before filing; thus, if there has been any offer for sale or public disclosure, the ability to obtain protection may be lost.

8. Using third-party copyrightable content without authorization. The Internet has made a wide range of copyrightable content ? including photographs, text, software and drawings ? instantaneously accessible. But easy access and the ability to download or reproduce this content do not mean that the copyright owner has granted such rights to the world. Online licenses contain the terms of use of Web site content. Many businesses needing content for their Web sites or marketing materials fail to read the legal statements and can be sued for copyright infringement.

The other source of copyright infringement is exceeding the restrictions on the use of computer software. Companies must be sure they have a well-developed policy that prohibits unauthorized copying, installation and distribution of software. IT personnel must be vigilant to avoid disputes with the various software industry associations that police software infringements for their members, such as the Business Software Association and the Software and Information Industry Association. Many violations are reported to these associations by current or former employees.

9. Adopting unenforceable noncompete agreements with key managers and employees. The departure of key managers and employees involved in invention can have a devastating effect on a technology startup company. In order to protect themselves from such situations, companies often require such employees to sign a noncompetition and nondisclosure agreement. However, such agreements must be narrowly drafted to be enforceable. They must be: Supported by valid consideration (payment or benefit to the employee); necessary to protect the company's interests; and reasonable in geographic scope and duration.

A frequent mistake is not having such agreements prior to beginning employment. Under Wisconsin law, if a noncompete is required of an existing employee, it must be supported by more consideration than a promise of continued employment. The grant of stock options or a monetary payment may be sufficient consideration in most circumstances. In Wisconsin, if any provision of a noncompete agreement is unenforceable, the entire agreement is deemed unenforceable.

Companies must also be sure to inquire of a prospective hire whether he or she has signed a noncompete or nondisclosure agreement with a former employer. Doing so will allow the company to avoid becoming embroiled in a lawsuit brought by the former employer based on an interference-with-control claim.

10. Failing to instruct employees on proper use and subject matter of electronic communications. Inevitably, Exhibit A in recent intellectual property cases is an e-mail that suggests deliberate copying of a competitor's copyrightable or patentable intellectual property. Willful infringement in patent, copyright and trademark cases can greatly increase the financial exposure of a company, especially if treble damages in patent cases are awarded. The informal nature of e-mail communications can result in language that is easily misconstrued. The broad obligations of electronic discovery require that employers be well-informed on these issues and that communication policies be in place early.

The top 10 mistakes tech companies make

By Gina Carter

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