Thoughts on startups by investors that
fund them & entrepreneurs that run them

Rookie Cookies: Owning the Batter But Not the Chips

I’ve gotten on my soapbox before about the importance of forming a business entity as soon as there’s a new product or business worth protecting.  The most common messes encountered in my startup law practice involve founding teams that somehow never got the formation done right, including the contributions and assignments of intellectual property to the new company and the related issuances of stock to founders and other contributors.  As they say, an ounce of prevention is worth a pound of cure, so let’s drill down and look at the places where things can go right or wrong.

Humor me with an analogy.  Suppose we’re tasked with making a large quantity of chocolate chip cookies for the school bake sale, working as a team, but without any written recipe.  A newly incorporated company is like the empty mixing bowl.  Each co-founder or other early contributor prepares or buys the various ingredients and dumps them into the bowl; everything gets mixed together and goes into an oven on baking sheets; and if all goes well, the process yields hundreds of mouth-watering cookies that make the work that went into them seem well worth the effort.

Now suppose you’re the school that wants to sell these uniquely delectable treats (let’s call them “Mr. Johnson’s”).  Motivated purely by crass commercial considerations — after all, this is for a good cause — what are some issues to consider?  For starters, the quality and quantity of the cookies will depend, among other things, on the quality of the ingredients, the respective skill levels of the bakers, and their ability to work together as a team, without a recipe, such that the total is worth more than the sum of its parts.  That may not seem very relevant to startup legal issues on the surface, so let’s get down to business:

  • Supposing each baker gets some kind of credit from the school for his or her contributions, how are the cookies (shares) divided up? Who gets how many? What are the governing principles?
  • Where did the ingredients come from?
  • Where did the bakers learn how to make cookies?  Whose recipe was used (if only by memory), if any, or was it just application of common baking principles and accumulated know-how?
  • How much time and effort did each person on the team put in?

It should be apparent that without understanding of, and agreement on, these issues up front, our cooperative bake sale becomes rife with potential disputes.  This has the makings of a great classroom discussion that would tear at least half of the students away from Angry Birds on their iPads.  But first we need to address the question raised by that wiseass slouched at the back of the room:

“Who cares?”

Lawyers are rightly accused of getting bogged down in details, missing the forest for the trees by building every conceivable contingency into documents — adding time and expense to the deal process — rather than focusing on the areas of greatest value and risk that really matter.  Outside the halls of academia, that student’s question is legitimate, not flip.  When and why does this matter?  It depends.  Continuing our cookie metaphor:

  • If the cookies are horribly charred, dry and inedible, it doesn’t really matter.  Legal niceties are purely academic.  Nobody can be bothered to assert rights in something that is worthless.
  • If the cookies are taken to a party and given away for free, practically speaking, it probably doesn’t matter either.  (This is analogous to many cases of fair use in copyright or trademark.)
  • If the cookies are taken to a culinary school to be handed out in a class for analysis, tasting and discussion, it also probably doesn’t matter (fair use again).
  • If the cookies are the most popular item at the bake sale, selling out immediately, generating insistent demands for more batches to be made, requests for the recipe, offers to buy packages of mix or raw dough to be baked at home, interview requests for the bakers and so on, it matters.
Needless to say, this last bullet point is every entrepreneur’s goal.  The reason we care is the very reason founders put blood, sweat and tears into their ventures in the first place:  If they succeed, they will have created something of enormous value.  The more valuable it is, the more closely scrutinized it becomes by everyone ranging from competitors to customers, potential investors, acquirers, patent holders, regulators, journalists, you name it.  If you think I’m exaggerating, read the 22 pages of risk factors in Facebook’s registration statement on Form S-1 for its forthcoming IPO.
Granted most entrepreneurs, no matter how successful, won’t create another Facebook.  Nevertheless, the point remains that the cost (however calculated) of preventing IP- and formation-related risks is essentially fixed, while the benefit varies from minimal to enormous ($65 million in the case of the Winklevoss settlement, not counting legal fees).  So back to our cookies, looking at areas of potential dispute:
  • What if nobody agreed up front how to divide up credit for the cookies?
  • What if somebody took ingredients from another bakery where they worked during the day?
  • What if somebody copied the recipe that a competing bakery used (to the extent they could remember it)?
  • What if somebody brought the ingredients but neglected to dump them into the bowl with everyone else?
  • What if someone was involved in a minor way (say an assistant to one of the bakers) but the group completely forgot about that person until he showed up at the very end demanding his share?
These acts, omissions and ambiguities are what keep litigators in business.  Some of my best friends are litigators; they’re nice people who deserve to earn a good living, but that doesn’t change the fact that startups are best off never having to meet them.
So how to avoid an ugly dispute in which it may be determined that you don’t actually own the chocolate chips used in your cookies that Modern Baking wants to photograph for its cover story?  Here are some lessons learned from bake sales past, successful and unsuccessful alike:
  • The company needs to own everything.  Founders, employees, hopefully investors and/or acquirers someday will own shares in the Company, not in individual people.  This is why startup lawyers are obsessive about obtaining IP assignments from every person who touches the new business at its formative stages.
  • Calling someone a founder (or not) doesn’t change the rules.  It matters for purposes of symbolism, respect, investor relations and so forth, but there isn’t anything automatic that occurs with respect to a founder as opposed to an early employee or contractor.  This relates to the next point:
  • Forget everything you may have heard about “work for hire.”  Yes, there is a doctrine in U.S. copyright law that applies to people who are employed by companies.  It doesn’t apply to contractors, may not even apply to founders or employees in some circumstances, and shouldn’t be relied on for other types of IP rights.  Get it in writing.  Good startup lawyers have documents ready to go that cover everything, taking a “belt and suspenders” approach, to ensure the Company owns all of the assets created on its dime.
  • Quarantine everything from past or other employers, both physical and intellectual property.  State law varies on the subject, but in general, if an employee develops something related in any way to the work he or she is being paid to do by another company, there’s a strong chance that company could claim ownership to the resulting IP unless the work is done completely on the employee’s own time, using his or her own equipment (no company laptops or smartphones!) and without referring to any of the employer’s IP.  This is an article of faith in Silicon Valley, but seems to be less well known in other places.  You can’t erase knowledge in your head, but investing in a dedicated computer, separate email accounts, cloud storage and other resources for your startup should be a no-brainer these days.
  • Mistakes happen.  Inevitably things will turn up that were forgotten, overlooked or even concealed.  Assuming they aren’t the core “crown jewels” upon which the entire business is built, it’s usually possible to clean up any problems early on.  Encourage openness within the team and with the Company’s lawyers.  Otherwise, assume that any issues that are swept under the rug will be uncovered by opposing lawyers doing diligence on behalf of an investor, underwriter or acquirer years later, on the eve of closing a deal that could be worth millions, when whoever arguably holds the missing rights or needs to sign a piece of paper is nowhere to be found and/or inclined to hold up the deal for maximum extortion value.
  • Guard the door.  At inception, when founders form a startup, they contribute everything developed so far to the Company in exchange for equity.  After that, going forward, everyone who does work for the startup should be required to sign IP assignment agreements.  Make it a step in the hiring process for new employees or the engagement of new contractors.  When people leave, have them sign a “termination certification” reaffirming their obligations under the agreement they signed when they first joined the company.
  • Protect yourself.  I’ve rarely met engineers or other technical types who don’t have some kind of side project going on, even if it’s a completely unpaid hobby.  That’s fine, and it’s in everyone’s best interest to be transparent about it.  IP assignments for tech startups contain a place to list other “inventions” (however defined) that the new hire wants to claim as his/her own and not assign to the Company.  Taking the opportunity to clarify that Side Project XYZ isn’t related to the business and falls outside the stope of the IP assignment agreement is a good idea for everyone involved.

 
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship. All opinions expressed are those of the author, and do not necessarily represent those of Gust.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

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