Avoiding Legal and Financial Traps

Avoiding Legal and Financial Traps

Stephen Goodman, a partner in the Philadelphia office of law firm Morgan Lewis & Bockius, sees himself as a pediatrician for young companies, making sure their growing pains aren't something much worse. Goodman spoke with Senior Correspondent Amy Barrett about how to avoid the legal and financial traps that can ensnare fast-growing startups.

Q: What are some of the common mistakes entrepreneurs make?

A: On the most basic level, some entrepreneurs do not actually have the right to start their companies. They could have been employed by someone else when they developed the idea for their company. If they signed an agreement giving their former employer rights to anything produced while working for them, they're open to a lawsuit. Or the entrepreneur could have developed the idea on company time and property, in which case they also don't own the idea.

Q: What can be done to fix this? A: The best bet would be to get a licensing deal or permission from the employer. The entrepreneur should go to the employer and say, "I want you to have a piece of the action."

Q: How about intellectual property?

A: Well, sometimes the idea for the company has been patented by someone else, and the entrepreneur doesn't have a licensing deal. You'd be surprised how many people don't go on the Web and do patent searches.

Q: What other legal problems trip up companies early on?

A: Often entrepreneurs have chosen a structure that can become a problem. For example, if you are a Subchapter C corporation and ultimately you want to sell the company, you can have an issue. Most often buyers want to conduct an asset purchase rather than a stock purchase because of the tax advantages. But if you try to sell that way as a C corp, you, the seller, would have to pay taxes twice: once as the selling corporation and again as a shareholder in the company. Economically that makes no sense. As a result, you need to do a stock deal. But since the buyer doesn't get the same tax advantages in a stock deal as they do in an asset purchase, they are going to lower their price. So if you're thinking of eventually selling the company, it may make more sense to set yourself up as a limited liability company.

Q: Can equity compensation be a problem?

A: It can be a huge problem. What happens if you give an employee 100 shares at the same time that you're raising money at $100 a share? The employee should pay taxes on $10,000 in income. There are ways to structure equity compensation so that there is no present tax liability, and to improve your chances of having the money made treated as capital gains.

Q: How can a new company afford all this legal advice?

A: If we believe [a startup] is going to get funded, we'll do this sort of basic work on a retainer, based on what the company can afford. We do a lot of work not covered by that retainer with the confidence that we'll get paid later. That used to be an unusual thing for a law firm to do. Now there isn't a regional or national firm with a practice focused on emerging growth companies that doesn't do this.

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