New Model Startup Docs Give Entrepreneurs a Head Start - Do You Still Need a Lawyer?

Startup companies just got new tools to make the formation process a little easier.  With the help of the law firm Wilson Sonsini Goodrich and Rosati (if you are a California startup, you have undoubtedly heard of them), TheFunded.com offered up this week its contribution to the recent and growing trend of publishing early stage documents for startups and emerging companies with publication of the following form documents:

• Bylaws
• Certificate of Incorporation
• Initial Stockholder Consent
• Invention Assignment Agreement
• Restricted Stock Purchase Agreement
• Indemnification Agreement
• Initial Board Consent
• Action by Incorporator
• Plain Preferred Term Sheet

These are the basic documents used by startup companies to get their ventures off the ground.  The Certificate of Incorporation is the only document that is filed publicly with the state, the others govern internal matters within the company.

This is not the first set of legal documents to be released, but most of the other forms have been in the early stage equity investment area.  Wilson Sonsini itself published a term sheet generator for each stage venture investment deals, TechStars published a set of model early stage investment documents earlier this year, and of course, there are also the National Venture Capital Association forms for early stage venture investments that have been out for several years.  In fact, other firms and organizations have released form documents in an effort to make the process of formation early stage financing easier, cheaper, and more efficient.  Wait, did someone accuse lawyers of being inefficient?

So startup lawyers are now expendable?

Don't jump to conclusions too soon.  These documents can give you a sense of what is involved in formation and also provide a baseline for your final agreements.  However, there are still many things here that you should discuss with your attorney.  There is no such thing as a one-size-fits-all set of formation documents.  Each company will have individual needs based on the structure of the organization, the people involved, etc.  For example, you should at least consider the following:

1. These documents assume that your startup is incorporating in Delaware and is located in California.  State laws of formation differ and your state may have different requirements that will have an impact on the documents.
2. These documents are founder-friendly in that they give a lot of control to the entrepreneurs who form the company.  That is great for the entrepreneurs but may become problematic if you have other investors or third parties involved who want to share in that control.
3. You may need to consider an additional agreement for the founders to cover other contingencies that affect their relationship.  Remember that everyone is happy to be in business together at the beginning.  But a little planning up front will help to resolve disputes later.
4. If you sign a restricted stock agreement, you will likely (in almost all circumstance) file an 83(b) election.  This must be filed at the time you sign or within 30 days in order to enjoy the benefit of recognizing tax on the value of the shares of the fair market value (which should be $0.00 at the time of grant because they are given at fair market value).  The alternative is that you will be taxed at each stage of vesting - if the company increases in value, you could be stuck with a tax bill each time without any liquidity (i.e. no cash is paid to you at vesting from the stock).

The bottom line is that forms like these give some more power to entrepreneurs in taking control over the formation process.  And because they come from reputable organizations, you can have a piece of mind that you might not find with other online sources.  But with this new control comes the responsibility to make sure that you understand what you are getting into.   A good startup attorney can walk you through the pros and cons of these documents so that you can feel confident that you are setting up a strong organization.

Massachusetts Data Privacy Regulations Get Delayed ... Again

For those of you stressing over the changes to personal information policies and procedures required by the pending Massachusetts data security regulations, you can breathe a sigh of relief... sort of.  The deadline for implementing the new policies has been pushed back - for the third time.  Now the new regulations will take effect on March 1, 2010 (rather than in January), and some of the more controversial aspects of the law have been watered down to make the requirements more palatable to small businesses. If you are a business owner who is not aware of the upcoming changes, you need to take a look.  The far-reaching regulations are a response by lawmakers to the highly-publicized security breaches at TJX, The Boston Globe, and others where thousands of social security numbers, credit card numbers, and other personal information were carelessly unsecured.  As described by Mass High Tech:

The Massachusetts regulations, first promulgated last fall based on a legislative directive, will go further than any other state by requiring any company that handles state residents’ sensitive data to take measures to protect it. Measures include encryption and extend to ensuring that all third-party IT service providers adequately protect sensitive data — a clause that drew criticism from business owners as an onerous requirement.

Specifically, the revisions to the data security regulations moderate the specific requirements to make them more consistent with the federal privacy requirements under the Gramm-Leach-Bliley Act.  The new Massachusetts privacy regulations apply to any business - yes, even outside of Massachusetts - engaged in commerce that collects and retains personal information of Massachusetts residents in connection with the provision of goods and services.  While these regulations will apply to all businesses regardless of size, the new revisions make clear that the regulations will apply a risk-based approach based on the size and scope of each business. (i.e., smaller businesses storing small amounts of information will be required to take different actions than would a large company with much more information and resources).

So, what does this mean for you?

If you are a business owner who collects the first name or initial and last name of a Massachusetts resident in combination with that resident's (a) Social Security number, (b) drivers license or state issued identification card number, or (c) financial account number or credit or debit card number, you must comply with the new regulations by March, 2010.  That includes, at a minimum:

1. creating a comprehensive information security program for safeguarding against "reasonably foreseeable internal and external risks to the security, confidentiality, and/or integrity" of the personal information, including employee training and education;
2. encrypting all data and files containing the personal information to the extent "technically feasible" and maintaining "reasonably up-to-date" firewall protection and operating system security patches; and
3. taking "reasonable steps" to select and retain third-party service providers that are capable of maintaining appropriate security measures consistent with these regulations and any applicable federal regulations.

The steps that were originally included as required actions are now offered as guidance to comply with the regulations, but whether a company is ultimately in compliance will be determined on a case-by-case basis.  In any event, all businesses should take a look at their data security procedures to make sure they are up to date.

Are you concerned about how the new regulations will affect you?  What do you see as the biggest challenges to comply?

Not too big to fail: the end of BigLaw?

Recessions typically force businesses to tighten their belts and make some temporary changes as they wait out the storm.  But doesn't this one seem different?   Doesn't it feel as though it is reaching formerly untouchable sectors of the economy and encouraging a willingness to completely rethink the way things have always been done? One such example is big law firms.  Check out Douglas McCollam tearing down the current big law firm model in the WSJ:

At bottom, what’s in question is the whole economic edifice of the modern American law firm. Like the pharaohs of old, big firms are enamored of constructing pyramids with an ever-widening base of associates and nonequity partners toiling on behalf of a narrowing band of equity partners at the top. Increasing a firm’s “leverage”—as expressed through the billable hour, one of the most pernicious creations in the annals of commerce—has been the key metric driving profitability at big law firms over the last generation.

Along with the growth and "hubris" that has created international legal institutions that rival the size of some of their larger clients came excess:  now junior associates in Boston and other major cities are making $160k to start, plus bonus, and are often billed out at $300 - $500 per hour -- rates which used to be reserved for partners -- making million dollar partner salaries commonplace.

I am certainly not suggesting that the big law firms are going away.  However, businesses are rethinking the model in light of this deep recession and what they want out of their relationships with their lawyers.  There will certainly be some changes going forward.

This is particularly pertinent to startups and small businesses.  Jason Mendelson, co-founder and Managing Director of Foundry Group, has written extensively and convincingly of the effect on startup companies from a venture capitalist's perspective in an entire series of blog posts called Law Firm 2.0.  These are definitely worth a read; there are a lot of lawyers out there - myself included - who are seeking new ways to accomplish our clients's goals from their perspective, not the lawyers's.

What do you think?  What would you most like to see from your lawyer?

UPDATE:  It seems McCollam's Op-Ed and the discussion about Law Firm 2.0 has struck a nerve.  Is there actually a big difference of opinion here?  Having worked at big law firms, I have seen a variety of views.  Few were in favor of maintaining the status quo, but each had a different perspective for "fixing" things depending on where they sat on the pyramid.

What do you see as the real debate, and where do you see the fault line?

The Other Thing You Learned at College For Your Small Business

Remember sitting in class in college listening to a professor fill you head with knowledge that would eventually form the basis of your business?  Well now the time you spent in the dorm might help as well.  Small and startup business are increasingly sharing office space.  This system of "co-working" - sort of like finding a roommate for your business - is catching on in this economy because it offers more flexibility and lower costs to startup businesses.  According to the Wall Street Journal:

[S]mall business owners and professionals share space and office equipment, and pay short term leases, usually month to month. ... For entrepreneurs, it's a cheaper and more flexible alternative to renting or buying space of their own.... [Tobias] Roedinger estimates he is saving $300 to $400 per month on utility bills and not having to rent space he doesn't need.

Even more interesting is the fact that these co-working spaces are sometimes employing bartering rather than rent. According to Winnie Fung, a manager of a nonprofit co-working space in Brooklyn, N.Y.:

At least three or four people from the 10 in her co-working space have partially or fully bartered their services for desk space. ... Ms. Fung says a few months ago she made a deal with one of her members, a tech start-up owner, to look after the building's computers and Internet service in return for free space.

As I have written about before, start-ups will do themselves a service by bootstrapping as long as possible when getting started in order to maintain control and options for later.  This type of cost-reducing move can not only improve your bottom line, but also provide added networking.

What happens next? Four tips for planning succession in small businesses.

I have been working with a few small companies that are run by founders or the children of founders and they inevitably come to a point where they start thinking about how the business would run without them. Early on, this idea doesn't even cross their minds; they naturally spend their energy on how to run the business and are not thinking about how to leave the business. This often comes up in the context of retirement, particularly where one or more of the partners does not have an "heir" to take their place.  Depending on who the current partners are, those willing to take the helm may or may not be seen as "worthy".

But all small businesses should also think about the dreaded unplanned exits:  what if one member dies or is permanently disabled?  Some planning now in the form of a Shareholder Agreement (sometimes known as a "Buy/Sell Agreement" or "Cross Purchase Agreement") can save the company and its partners stress and expense down the road.

So what should you consider when planning such an agreement?  Like any contract, you can choose from a number of options, but I typically advise as a baseline to consider the following:

1. Restriction on transfers of stock or membership interest.  A small company will likely want to restrict who is coming and going as an owner because of the inherent close nature of the partners's relationship.  The partners may want to prevent one partner from going out and selling his ownership interest to someone undesirable to the other partners.  This is typically done with an outright restriction on transfer unless the interest is first offered to be sold to the company and/or the other partners first.  This offers some stability to the company and the other partners to move forward.  In the event they refuse, then the selling partner may transfer the interest with the inferred consent of the others.
2. What are the "trigger" events for a purchase of a partner's interest?  This agreement generally allows the partners or the company (or both) the right or obligation to purchase one partner's interest in the company in the form of stock or some other membership interest.  Many companies will have a trigger on the event of the partners death so that the interest is purchased from the surviving spouse (this is both as a consideration to the spouse and because the other partners may not be interested in partnering with that spouse).  But you should also consider whether there should be a trigger for a partner's permanent disability preventing them from continuing in the business.  Or, under better circumstances, what if one partner just wants to retire?  The last one is harder because of the lack of objective measures, but will certainly be of interest to the partners at some point.
3. How do you define the trigger events? A partner's death is a pretty easy trigger to recognize, but when is someone considered disabled to the point that the company should repurchase her interest?  Generally, the disability should be described in detail with objective standards (e.g. mental or physical illness that incapacitating a stockholder from performing normal duties as director, officer, or employee for a period of six consecutive months or any six months in a 12-month period).  Obviously, these can change depending on the circumstances, but are an example.  Often, that determination must be made by a licensed physician, or in some cases, more than one if a second opinion is required.
4. How do you fund the cross purchase? (and yes, you should fund it).  When the agreement is triggered and the repurchase of stock by the company or the cross purchase by the other partners is required, what if they don't have the money?  There are insurance products that can help here.  For example, when one of the partners dies, a life insurance policy taken out on her life can be used to pay for the stock repurchase.  But if you have a trigger for disability, you might also want disability insurance to cover (in which case your trigger should match the insurance policy definition of "disability").  This gets a bit more complicated when you decide how to purchase the policies - whether the company is the insured or the individual partners take out personal policies on the lives of the other partners.  The premium prices will be different depending on the age and health of the partners, and there are some different tax treatments depending on whether the company of the partners hold the policies.  Finally, in the event of a partner's retirement, funding cannot be done through insurance so you may consider paying by financing the purchase price over a period of time.  That of course will depend on the nature of the business (and the partner's view of the long-term success of the business).

There are many other considerations you may want to take into account in negotiating among the partners, but these should be considered as a baseline.  Your attorney and accountant can also provide additional thoughts on how your agreement will impact your particular situation.