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?

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.

Franchising works, but does it work for you?

We have all been to a McDonald's, Taco Bell, or other franchised restaurant.  No matter where you go, a reliable menu is waiting in familiar surroundings.  These systems are examples of an established business model where independent business owners buy the rights to operate their restaurant with the look and feel of any other restaurant in the system. But franchising is not just for fast food.  Franchised businesses are responsible for $2.31 trillion which represents 11.4% of the total private sector output in this country and up to 40% of all retail sales!  Franchises come in all sizes and flavors - I have personally represented casual dining restaurants, a dog training business, an educational learning center, health club, and other systems.  You can find franchises is just about every industry operating in the U.S. today.  So franchising clearly works.  But will it work for you?

A franchise is born whenever a business relationship meets three criteria:

1. The right to use a trademark or trade name,
2. Some type of marketing plan or system created by the franchisor, and
3. A fee paid by the franchisee.

The parties cannot opt out of the franchise regulation; if you meet the three-part definition, you have a franchise and must comply.  Failure to follow the rules can result in fines and other penalties.

Here is an example:  I was speaking with a business owner who has been operating for several years and has established two successful locations.  He was interested in expanding, but couldn't find financing.  He was approached by entrepreneur who was interested in opening a few other locations based on the established name and concept.  The store owner was willing to grant the entrepreneur the right to use the name of the business, but he expected some type of payment for that right and he wanted to make sure that the new stores would be run in a similar fashion to his since he spent years developing good will with his customers.  It sounds like a win-win situation: the business is expanding, but the business owner does not have to put out the capital to open the additional locations, and the entrepreneur is leveraging the proven model into starting his own business.

However, it is not without concerns.  Franchise regulation is neither a simple nor inexpensive process.  And while many successful businesses have enjoyed rapid growth through franchising, you must have an understanding of the definitional requirements, particularly if you are trying to avoid falling under the regulatory umbrella.  The franchise laws and regulations control the process of selling franchises - everything from the initial meetings, to signing the paperwork, to operating.  And the rules were rewritten last year, making the current state of the law even more complicated.

But before you launch into franchising, consider the following:

• Is the business franchisable? Many businesses are prime candidates for the franchise model, but others are not.  Franchises exist in almost every industry from food and retail to auto parts to education to professional services.  But a business built around a person's unique personality, for example, may not be reproducible elsewhere.
• Is there a need and is the business scalable? You may be able to keep up with current demand by producing your product in-house with a solid team.  But will the need grow with the increased availability of your product or service?  A healthy franchise system will require an exponential growth in the delivery of raw materials or other services underlying your business.
• Are you ready to give up "your day job"? Whatever business you were in before you decided to franchise, you are now in the business of selling franchises.  Creating and maintaining a franchise system requires a full-time effort and attention to business and legal issues surrounding your own company and the needs of your franchisees.
• Are your finances in order? Franchising is a great way to develop a system using other people's capital.  However, there is still a significant capital requirement to get up and running and to provide continuing support services to your franchisees.
• Where will you franchise? State laws will require that you have a franchise plan before you start talking with prospective franchisees.  Failure to comply with state requirements could result in fees and other penalties.  Many franchise systems start in one state or a region and gradually increase their presence to avoid the financial and legal burdens of nationwide compliance all at once.

And of course, there are many more.  Franchising is a proven business development method that has helped thousands of businesses employ millions of workers.  Whether it is right for you will depend on many factors.  By consulting with experienced professionals like franchise lawyers, accountants, and financial experts, you can determine whether you are ready to take the next step for your business.

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.