Startup Law 101: 5 Mistakes That Can Blow Up Your Startup – Don’t Sign the “totally fine” ChatGPT Contract

Startups move fast, but legal mistakes move faster—and they hit harder. Whether you’re bootstrapping or backed by big VC, your lawyer isn’t just a formality—they’re your firewall. Too many founders treat legal like an afterthought, then wonder why things explode. From boardroom to courtroom, these are five founder mistakes that separate the bold from the bankrupt. So, before you launch that app, hire that friend, or sign that “totally fine” ChatGPT contract, read this:

1. Don’t Wait Until You’re in “Oh Sh*t” Mode to Call Your Lawyer

In the startup world, things move fast—your legal strategy should move faster. Waiting to bring in counsel until there’s a co-founder fallout, a misfired contract, or a surprise lawsuit is like trying to install brakes after your Tesla hits 90 mph. We’ve seen it all: 

• One founder stops showing up but still owns half the company because no one drafted a real agreement. 
• Someone grabs a one-page operating agreement off Google that leaves you stuck with default state rules that don’t fit your company’s needs. 

A little legal foresight upfront saves hours of cleanup later.

From Commodity Trading to Contract Law: What Entrepreneurs Can Learn About Risk

Before I became a transactional attorney, I was a grain trader. If you’re ever in an airport, you can spot a grain trader rather easily. They will be the person in a polo, grain company brand over their heart, pacing back and forth, trying to get just a little more phone time in before they take off to someplace else. On any given day, I might have fielded a hundred phone calls and reviewed well over a hundred pages of contracts before heading home. The pace was relentless, but what mattered most was precision. If you didn’t know the rules, the actual, technical rules, and understand the “industry rules,” you could expose the company to hundreds of thousands of dollars in losses from a single mistake. The margin for error was zero.

Buy-Sell Provisions: More Than Just an Emergency Plan

Regardless of the type of entity, every business has or should have (more on the should aspect below) a governing document that is at least a basic agreement among its owners that governs (1) the operation of the business and (2) the owners’ contractual rights, obligations, and restrictions with respect to their ownership interests in the business. The second of these contains what are commonly referred to, by lawyers at least, as the “buy-sell” provisions. If for some reason the owners decide not to enter into a written governing document, then the statutory default provisions of the business’s state of formation (which vary from jurisdiction to jurisdiction) automatically govern the entity and the owners. For example, if an owner of a limited liability company is determined to be legally incompetent to manage their affairs and the business either doesn’t have a governing document or that document is silent as to the treatment of an owner’s interest in the event of legal incompetence, what happens? Under Delaware law, the most widely recognized state of formation for businesses, the owner’s personal representative can effectively step into the owner’s shoes as an owner, thereby resulting in a previously unrelated (and likely inexperienced) third party having an active ownership interest in the business.

Updated Resource for Entrepreneurs and their Lawyers

The National Venture Capital Association (NVCA) sets the standards, quite literally, on the forms used by most emerging businesses looking to raise capital. Founded in 1973, the NVCA is a research, advocacy, and professional development network—a non-profit organization supporting the venture capital industry and the various players that make up the community.

Keeping Good Records – An Often Overlooked Element of the Business Exit Plan

With all of the long nights and frantic days that can come with starting and running a business, the practice of keeping paperwork neatly organized can easily fall to the bottom of a to-do list. It is certainly understandable that you might consider time spent networking with potential customers and funding sources to be far more important than making sure your company’s contracts are organized in a logical order; however, having a good handle on your paperwork can be more important than you may think.

If you suddenly find yourself awash with customer demand, you may also soon find yourself across the table from a sophisticated investor that is offering either to invest a large sum of money or, hopefully, to acquire your business for an even more tidy sum. That investor is going to want to conduct its due diligence on your business to ensure it is worth the money. The diligence process can be lengthy and expensive for both the investor and you.

What's the Catch?

As fall starts, so does collegiate sports. I recently sat down to watch one of the numerous Saturday college football games and heard the announcers discussing all the money this year’s collegiates were making through their recently sanctioned ability to use their name, image, and likeness (NIL).

This led me to thinking about how these young entrepreneurs are rapidly building their brands and generating income, but at what cost?

A recent article published by ESPN discussed an NIL deal involving current Chicago Bears rookie Gervon Dexter. Dexter signed an NIL deal with Big League Advance Fund in 2022 while attending the University of Florida. Dexter’s deal provided for Dexter to receive a one-time payment from BLA of $436,485 in 2022 in exchange for 15% of Dexter’s pre-tax NFL earnings for 25 years. For Dexter, this means paying BLA an estimated $1.008 million based on his present NFL contract terms ($6.72M over four years).

Farmers Are the Ultimate Entrepreneurs

Fall is here (although it looks like winter outside at the moment!). This time of year always makes me think of farmers across the upper Midwest harvesting their crops. I consider farmers to be the ultimate entrepreneurs and, generally, some of the smartest and most determined people I have ever met.

Like many entrepreneurs, 2020 has presented a lot of challenges for farmers who, even before this year, were already battling declining profit margins, low commodity pricing and increasingly unpredictable and extreme weather patterns. Farmers are constantly innovating, growing businesses by themselves and taking full responsibility for the success of their products, from seed to harvest. I think entrepreneurs can learn a lot from America’s farmers.

Here are three things entrepreneurs can learn from farmers: 

• Use your mission as motivation. For an entrepreneur to be successful, the entrepreneur better have a mission that matters and motivates them. A farmer’s mission is to produce the world’s food and other essential agricultural products. Farming is essential and fundamental to society. An entrepreneur’s mission should be equally as critical.
• Employ data analytics. Farmers rely on sophisticated data analytics to aid their decision-making, such as what crops to plant and when to plant them, whether to contract in commodity futures and when to sell products. Data allows farmers to evolve and to avoid relying solely on historical practices to dictate future actions. Entrepreneurs should use data to help them innovate with knowledge and confidence, particularly when you’re operating in a high technology environment where things can change rapidly.
• You are only as good as you word. Farming communities are typically small and a farmer’s word means everything.
  Trustworthiness matters and can be a key driver in establishing a positive business reputation, business longevity and key business relationships. Of course, written agreements are relevant and can be important (how could a lawyer like me say anything different). Like farmers, entrepreneurs should value their verbal commitments at least as much as written legal agreements. 

There exists a misconception that farmers and farming are behind the times. Those of us who work with or have been exposed to farmers feel the opposite way. Just like high tech startup entrepreneurs, farmers frequently embrace innovation, work tirelessly and are among the first to take on risk and innovate if there is a potential return. 

USING E-COMMERCE TO SURVIVE COVID-19

Businesses have been forced to close their brick and mortar stores. We are all practicing safe distancing. People are working remotely. COVID-19 has already had a significant impact on how we conduct business. 

While the digital transformation was well underway before COVID-19, the transition to more vigorous and expansive e-commerce has never been more apparent. Amazon was set to hire over 100,000 new employees by April 1. Zoom has replaced all face-to face business meetings. Virtual interactions are the new norm. 

Nearly all companies now use some form of online or mobile websites and social media to promote their businesses, sell goods or services, conduct business transactions, and connect and communicate with customers, clients, or other businesses. 

For businesses that already enjoyed a robust e-commerce presence, now is a good time to review and enhance e-commerce strategies. For those businesses with a limited or non-existent online presence, their very survival may require a fresh look at e-commerce.

Wage and Hour Risks for Small Businesses

While I am not an employment lawyer, it doesn’t stop my entrepreneurial clients from calling with questions in that domain. It also doesn’t stop friends and family members, who assume having the title “Juris Doctor” means you are an expert on all things legal, from calling asking for me to guide them on employment issues — but that’s a topic for another post.

When clients call, I often provide some high-level thoughts on the issues (stuff that I have learned from some awesome colleagues, who actually are experts in HR-related matters) and, if they need more than that, I hand them off to these same colleagues on the 4th floor for more guidance.

Given that I frequently see early-stage entrepreneurs with limited cash resources struggling with employment-related legal issues, I wasn’t surprised that this recent article, titled “This New Kind of Expensive Lawsuit Could Easily Bankrupt Your Small Business,” was about the risks relating to the failure to comply with applicable wage and hour laws.

Keep Control of Your Venture

Every founder I work with is concerned about control. And rightly so, given that their new venture is their baby and the beneficiary of a lot of sweat and money out of their own pockets.

Usually the discussion gets interesting when the company begins issuing shares to employees or raising funds, but sometimes we dig into it right at formation. There are various creative methods to approach the issue.

Some traditional methods include implementation of voting agreements or the like, but for a startup looking to add and retain employees in a competitive market those methods may not be an ideal approach, plus they can be overly complex and it can become a burden making sure every employee signs an agreement that nobody other than legal counsel understands. Another method is to implement a dual-class of shares to give one or more founders the sole vote or “super” voting rights.

Managing the Risks of Your Relationship with Your Business Partners

Starting a business is an exciting time in your life.  Your days are filled with meeting prospective investors and advisors, and you are eager to go live with your new product or service.  But don’t overlook one of the most important decisions during this time: Who will you go into business with, and how can the risks of that relationship be managed?  
  
I’m not going to tell you who is or is not a good business partner.  Instead, I’m going to highlight some issues to which you should give special consideration.

SPIDERMAN TO RESCUE PATENT ROYALTIES?

Each morning as I gargle with Listerine, I am reminded that simple is sometimes best when drafting agreements. 

In 1881, Dr. J. J. Lawrence developed his now-famous antiseptic formula and agreed to make it available to Jordan Lambert. The simple two-sentence agreement used to transfer the Listerine formula reads as follows:

Know all men by these presents, that for and in consideration of the fact, that Dr. J. J. Lawrence of the City of St. Louis Missouri has furnished me with the formula of a medicine called Listerine to be manufactured by me, that I Jordan W. Lambert, also of the City of St. Louis Missouri, hereby agree for myself, my heirs, executors and assigns to pay monthly to the said Dr. J. J. Lawrence his heirs, executors or assigns, the sum of $20.00 for each and every gross of said Listerine hereafter sold by myself, my heirs, my executors or assigns. 

In testimony whereof, I hereunto set my hand and seal, Done at St. Louis, Missouri this the twentieth day of April 1881 Jordan W. Lambert.

Over almost 75 years, more than $22 million in royalties were paid to Dr. Lawrence and his heirs. The formula remained essentially the same. In 1959, Warner Lambert initiated litigation to void the agreement and end the royalty obligations. 

Warner Lambert argued that the formula was no longer a secret and the contract was unclear and indefinite as to duration. The court found in favor of Dr. Lawrence and his heirs: “There is nothing which compels the plaintiff to continue such manufacture and sale. The plain meaning of the language used in the agreement is simply that Lambert’s obligation to pay is co-extensive with the manufacture or sale of Listerine by him and his successors.”

Seventy-five years is fine with trade secret agreements, like the one covering Listerine, but you had better be careful when negotiating an agreement that includes patents. Royalties cannot exceed the 20-year patent term. 

Freedom to contract? Not so with patents. Just ask Peter Scheiber, the inventor of Surround Sound audio technology. Scheiber agreed in a patent license with Dolby to a lower royalty rate that went beyond the patent term. When Scheiber’s patent expired, Dolby stopped paying royalties. Even though the parties agreed to the extended payment period (at the request of Dolby!), the court determined that Dolby was not responsible for royalties after the patent expired. The court relied upon a United States Supreme Court case, Brulotte v. Thys. Co., 379 U.S 29 (1964). In Brulotte, the Supreme Court found that “a patentee’s use of a royalty agreement that projects beyond the expiration date of the patent is unlawful per se.”

Brulotte has been viewed by many as discouraging flexible licensing practices. Some have even suggested that this long standing rule has had a negative impact on licensing in the pharma and life sciences industries and is an impediment to new medical treatments being brought to market. 

Though heavily criticized, Brulotte has remained the rule followed for patent licensing for over 50 years. But a recent Supreme Court case may finally put an end to Brulotte. 

On March 31, 2015, the United States Supreme Court heard oral arguments in Kimble v. Marvel Enterprises, 727 F.3d 856,863 (9th Cir. 2013). Stephen Kimble, the inventor of a toy that shoots foam string from a glove, settled a patent dispute with Marvel that resulted in an agreement that provided Kimble royalties for web-blaster products. When the Kimble patent expired in 2010, Marvel—like Dolby—cited Brulotte and stopped making royalty payments to Kimble. The Kimble case has made its way up to the Supremes. 

Will Stephen Kimble suffer the same fate as Peter Scheiber, or will Spiderman prevail and save the poor inventor from lost royalty payments? 

Will parties finally be given the freedom to negotiate and structure payment streams for patents that are relevant and meaningful to the transaction at hand?

Will Brulotte survive the Spiderman challenge? 

Entrepreneurs should stay tuned and pay very close attention to the Supreme Court’s forthcoming decision in Kimble v. Marvel Enterprises, as it may have a significant impact on how they can structure payment provisions in intellectual property agreements. 

Tip: To extend royalty payments, consider a hybrid agreement that includes both patents and trade secrets/know-how. And remember Listerine.

The parade of NDAs

Non-disclosure agreements have been a regular part of my practice because so many of my clients have technology at the core of their businesses. Lately, however, it seems like I’ve been dealing almost daily with clients who are haggling over NDAs. Maybe it’s a sign that the entrepreneurs I work with are in an active state of deal making and wanting to engage in other strategic conversations – or maybe it’s just a sign of increased paranoia!

The interesting thing about this trend in my inbox is that it runs counter to a broader trend. A decade ago (or more, at the risk of showing my age), NDAs between entrepreneurs and potential investors weren’t that unusual. Today, in Silicon Valley and elsewhere, many (if not most) sophisticated investors refuse to sign them. 

While it is unusual for an investor to steal an entrepreneur’s idea (although allegations of theft are sometimes made) and the anti-NDA trend may not be ideal for individuals trying to protect their trade secrets, it is a reality they face. Investors claim they don’t want to expose themselves to potential risks because they may see “related” deals; they also claim that the lawyers (why does everyone always blame the lawyers?) get in the way and stall the dealmaking.

So what’s an entrepreneur to do? Well, you can’t just clam up and not talk about what you’re up to. You need to figure out how to talk about your business, the opportunity, and your technology. It’s about finding a way to talk about what’s interesting about the business and the opportunity without revealing the “secret sauce” that you’ve got.

Finally, remember that potential partners and investors are likely more interested in you and your team than they are in your idea. I’m not claiming as some do that your ideas have no value, but I do think that most investors are concerned more about the team and the “execution risk” than they are about the idea.

A decent idea with a great team is always a better investment than the best idea ever with an average team.

SkinnyGirl Gets Divorced

A few months ago I wrote about the real housewife turned mogul, Bethenny Frankel, and her massive deal to sell her SkinnyGirl drinks to Beam Global for $120 million.  In a matter of a few years, Bethenny went from near bankruptcy (despite her designer duds on the RHONY) to multi-millionaire.  She also went from single, to marriage, to motherhood in that same time frame.  And now, she is getting divorced.

I don’t pretend to be an expert in marital law, especially not in New York marital law, but I think this scenario lends itself to another discussion about owning closely held business assets and growing the company value, and the impact of premarital/postmarital agreements and divorce—as I discussed here and here.

Here are the basic facts: Bethenny built and advertised the SkinnyGirl brand prior to her marriage.  She grew the brand significantly as a member of the RHONY cast. About four years ago, Bethenny met her husband, Jason.  They were married a year or so after that and then welcomed a daughter a couple of months after the wedding.  The reason I point out the timing of the birth of their daughter is because Bethenny was pregnant when they negotiated and executed their premarital agreement.  A year or so after their daughter was born; Bethenny inked the $120 million SkinnyGirl deal. A year and a half or so from there, they are divorcing.

A dramatic change in circumstances from the time of the negotiation to the agreement to the time of enforcement of the agreement can be one of the biggest reasons agreements are thrown out or the courts alter the terms.  Having children, when no children had been contemplated in negotiating the agreement, can change the overall “fairness” of the terms.  This has nothing to do with child support—child support cannot be negotiated in a prenuptial agreement—but it does have to do with the expectations of the parties, lifestyle, and needs.  Selling a business or some other windfall can also impact the agreement.  

I don’t actually know the terms of their prenup, but it is possible that Bethenny was aware of the value of the company at that time or may have even been brokering its sale.  If the parties were both aware of the $120 million value and the possibility of the liquidity event, it is difficult to argue that this is a change in circumstances such that the agreement should be ignored.  However, adding $120 million to the balance sheet from relative bankruptcy is a significant change to the household lifestyle.  

Another factor here is likely the length of the marriage and the time between negotiation and enforcement.  Because this was a short union (yet longer than this marriage, this marriage, and this marriage combined), there isn’t much argument that Jason enjoyed the benefits of this lifestyle such that it would be a tremendous hardship to go back to his previous life.

The point of all of this is not to analyze Bethenny and Jason’s divorce, but to point out the impact of a liquidity event in a business completely built by the entrepreneur spouse, closely followed by a divorce.  If there are pieces of a prenuptial agreement that should be re-addressed or clarified, think about amending it or executing a postnuptial agreement.  If you have no prenuptial agreement, think about a postnuptial agreement that addresses this situation.  Issues regarding who can own the company or force liquidation of the company can (and should) be addressed in a buy-sell agreement, but that does not ensure that a divorce court will follow those provisions.  If you have a business, especially with other family members, think through what might happen if a divorce were to follow a significant increase in the business’s value.   

Thinking About Selling in 2012? Be Prepared to Show Buyer Why your Business is Worth What You’re Asking

For many of our entrepreneurial clients, the sale of the business he or she founded is the most obvious exit strategy when the entrepreneur no longer wants or is able to continue actively running the business and the entrepreneur’s children have not inherited his or her “entrepreneurial spirit.”

While a few of those entrepreneurs have been through a sale transaction before with other businesses they owned or when employed in other capacities before becoming an entrepreneur, for most of them a sale of the business he or she founded is a once-in-a-lifetime event. Having never participated in an M&A transaction before, it is hard to know what to expect or what is “normal.” 

One way we help entrepreneurs evaluate what is “normal” in their negotiations is by reviewing the results of various published studies, including the Mergers & Acquisitions Committee of the American Bar Association Business Law Section’s Private Target Mergers & Acquisitions Deal Points Study. The most recent iteration of this study was released in December 2011 and analyzes the frequency of certain material legal terms in 100 acquisitions of private companies completed in 2010. Of the transactions reviewed by this committee in 2011, almost half involved entrepreneurial sellers, so we know these results are relevant to what our entrepreneurial clients can expect in sales of their businesses.

I thought it would be interesting to compare the results of the 2011 study with those of the 2007 study, which analyzed acquisitions of private companies completed in 2006, well before most of us knew that we would soon be facing an economic crisis. 

When comparing the results, I expected that certain deal terms reflecting heightened buyer apprehension would be more common in the 2011 study than the 2007 study. Specifically, I expected that buyers would be demanding more post-closing remedies against sellers in the event of breaches of purchase agreements by the sellers. Certainly, it has felt to me that buyers have been more conservative than they used to be and less willing to take the risks that are inherent in any acquisition. What I found was that some of the most highly-negotiated indemnification provisions were almost the same in the two studies, but that there was a substantial increase in the use of certain provisions that arguably bear a more direct relationship to the bottom line.

Buyers in the 2011 study certainly seemed to be more concerned about overpaying for the target company than they were in the 2007 study. Post-closing working capital adjustments (usually requiring a target company to have some minimum amount of working capital delivered to the buyer at closing) were included in 68% of the transactions in the 2007 study and 82% of the transactions in the 2011 study. Additionally, the use of earnouts (additional purchase price to be paid to the seller upon the business achieving certain performance goals after the closing) to bridge a valuation gap between what buyers were willing to pay and sellers were willing to accept for their businesses increased from 19% of transactions in the 2007 study to 38% of transactions in the 2011 study.

By contrast, the primary contractual provisions that provide remedies to the buyer after closing were almost unchanged between the 2007 study and the 2011 study. There was no significant change in the period of time after closing during which a buyer was entitled to assert indemnification claims against the seller for breaches of the seller’s representations and warranties. In both the 2007 and 2011 studies, the most common survival period was 18 months, followed by 12 months and then 24 months (each appearing with similar frequency in both studies).   

Similarly, there was no significant change in (a) the amount of the purchase price held in escrow or held back by the buyer for some period after closing, (b) the percentage of transactions for which the escrow or holdback was the buyer’s exclusive remedy after closing, or (c) the cap amount for the seller’s general indemnification obligations as a percentage of transaction value. In both studies, more than half of the transactions had an escrow or holdback amount in the range of 7-15% of the transaction value and just over half of the transactions had the escrow or holdback as the buyer’s exclusive remedy. In the 2011 study there were actually a higher percentage of transactions in the lowest category of cap amounts, but overall the cap values were similarly distributed in both studies.

These few data points are, of course, just a small sample of the results of these studies, but they serve as a good reminder of something attorneys are prone to forget: the dollars and cents of a transaction matter most. Legal points and risk management are important, certainly, but favorable indemnification terms alone don’t make a financially unsound transaction suddenly attractive. My advice to entrepreneurs looking to sell their businesses is this: be prepared to show your buyer why your business is worth the price you are asking—whether it’s based on current financials or future potential. If you’ve done that, negotiating the legal and risk allocation points is likely to lead to similar results in any economic environment.

A Post by Alyssa Hirschfeld, Guest Blogger

Prenuptial Agreements: Why Jessica Simpson Might Actually Be Smarter Than The Rest of Us

Jessica Simpson is currently planning her second marriage with former NFL player, Eric Johnson. This time around Simpson plans to do some things a little differently. Not only has she managed to figure out that televising her wedding, and spending the first two years of marriage on a reality show, are not good ways to solidify the success of a marriage, but she plans to start with the ultimate asset protection device for every business owner—a prenuptial agreement.

The first time Simpson was married she thought Nick Lachey of the mega-band 98 Degrees (read my sarcasm) was her ticket to the good life. At that moment in time, maybe he was. The two of them had no idea she was bound for more than cheesy pop singles, a tagline about buffalo wings, or even a role as Daisy Duke. Today Jessica Simpson’s shoe and handbag empire is generating annual sales of around $1 billion. So what if she can’t sell albums to save her life, she has figured out how to provide for her family for generations. And this time around, she is smart enough to protect that. Or at least she was smart enough to listen to someone who told her to protect that.

Prenuptial agreements are not just for Jessica Simpson and other celebrities; they are really useful tools to provide for what happens to business assets at death or divorce. Without a prenuptial agreement, you face the possibility of running the business with your ex-spouse, your daughter’s ex-spouse, or the ex-spouse of your business partner. Even if you own the business completely in your name, and have owned the business since long before you were married, any increase in value due to your own efforts is likely subject to division at divorce. If you do not create the plan in what we lawyers call an “antenuptial agreement,” the laws of the state you live in will do it for you.

A common misconception about prenuptial agreements is that they are always in contemplation of a divorce and not a great way to start a marriage. More often than not, prenuptial agreements are done in contemplation of the division of assets upon the death of a spouse, not divorce. Even on death there are very good reasons to segregate business assets in a trust, pass them on to the child that currently manages the business, or to ensure the division and control is spread equally among a number of beneficiaries. Often the prenuptial agreement has nothing to do with restricting the spouse from enjoying the value of the business assets, but rather is about ensuring the assets stay with the family and are properly managed after the death of the business owner.

Signing a prenuptial agreement does not mean that you can never share the success of your business with your spouse. You can always provide more for a spouse at death in a will or trust, and most people do. A prenuptial agreement will simply keep the business assets safe and provide the only mandatory division of property at divorce or death. In addition, by law, prenuptial agreements must be fair to both parties when they are drafted and must be fair to both parties when they are implemented. This often means that even the non-business owner spouse, or the non-moneyed spouse, will be provided for fairly given the parties’ circumstances before the marriage, changes of circumstances during the marriage, and the length of the marriage.

What I commonly tell clients when they are thinking about whether or not to complete a prenuptial agreement is that this is not about hurting each other or pre-planning a divorce, but really this agreement is just another piece of your overall asset protection and business succession plan.