Laura Norris, J.D., an Assistant Clinical Professor and Director of SCU Entrepreneur's Law Clinic, analyzes the common misconceptions about founding a business and clarifies the proper information that founders should know.
In the next few minutes, I’d like to address three of the top misconceptions of startup founders. I’m providing you with general information, but this should not replace advice from a lawyer and tax adviser.
The first misconception is, “My co-founder is working in a day job, but that’s ok because she’s working with me during her own time.” Most startup founders are not independently wealthy and need that source of income. However, this type of situation can be risky because the employer might have a claim of ownership to your cofounder’s inventions. There are three sources of information you should look at. First, ask your cofounder to find the documents she signed when she joined the company. There is usually an “employee invention assignment agreement” that outlines what the employer owns. Second, she should get a copy of the employee handbook, which also may have an invention assignment provision. Finally, you’ll want to find out if your state has any laws relating to this issue. For example, if you’re in California, the Labor Code doesn’t allow an employer to own inventions that employees made on their own time unless the invention relates to the employer’s business, or results from a use of equipment or supplies of the employer. So, for instance, it’s possible that a car company in California could not claim ownership of an employee’s invention for a new lipstick developed on her own time, unless the she used the car company’s equipment in developing the lipstick.
The second misconception is, “We need to form a C-corporation in Delaware.” This seems to be the belief because venture capitalists prefer this form. However, one size does not fit all. When a business is very early stage and losing money, an S-corporation might make more sense because it may allow the founders to write off business losses on their taxes. If the company is not going to rely on venture capital, then it’s possible that a Limited Liability Company, or LLC, might be a better choice because it has the favorable tax treatment but is easier to maintain. There are important differences between these entities, especially relating to tax, so talk this over with your tax advisor. If you do decide to set up a business, consider doing it in the home state of the founders. You may need to register a Delaware business in that state anyway, and you’ll just end up maintaining two sets of filings in both Delaware and your home state. You should ask yourself – will you definitely need venture capital investment to make your startup successful? If so, then maybe the additional paperwork of filing in Delaware makes sense.
The third misconception is "Our IP is protected since we’ve been working with other developers and co-founders under an NDA.” Many people understand that “NDA” means “non-disclosure agreement”, but do not understand its limitations. The NDA is an agreement that ensures when a party (called the “discloser”) discloses information to another party (called the “recipient”), the recipient will keep it secret. That’s about it. Yes, it is important for cofounders to sign an NDA so they don’t go off and disclose the startup secrets to their friends. However, the NDA doesn’t address who owns the inventions, artwork, or other work product that might be created after the NDA is signed. If one founder walks away, he can take his contributions with him. What is needed, on top of an NDA, as an “invention assignment agreement”, or an “invention assignment clause.” So, for instance, if you enter into an agreement with your co-founders, that agreement should include an invention assignment clause. If you hire a contractor to write code for you, the contractor agreement should have an invention assignment clause. This will ensure that the company owns its intellectual property rights.