By: Laura Norris, J.D.
Starting a new business is risky, but avoiding the following misconceptions can reduce your risk. I’m providing you with general information, but this should not replace advice from a lawyer and/or tax adviser.
Misconception #1: Your co-founder can be an employee at another company at no risk to you or your business.
Most startup founders are not independently wealthy; they require another source of income while starting a new business. This type of situation creates risk because the employer might claim ownership to your co-founder's inventions. In order to avoid this situation, ask your co-founder to provide their hiring paperwork and employee handbook. The hiring paperwork usually contains an “employee invention assignment agreement” which outlines what the employer owns. The employee handbook may also have an invention assignment provision.
After identifying whether your co-founder’s employer poses a threat to your company, assess relevant state laws. For example, in California, the does not allow an employer to own inventions that employees make on their own time unless the invention relates to the employer’s business, or results from the use of equipment or supplies belonging to the employer. This means that in general, the company cannot claim ownership of an employee’s new gaming app if the employee develops it on their own time and with their own resources.
Misconception #2: You should model your business after the form preferred by venture capitalists.
You may have heard the phrase, “we need to form a C-corporation in Delaware.” While this is a popular business model, it is not necessarily the best fit for your business. For example, when in the early stages and losing money, an S-corporation might make more sense because founders may be able to write off business losses on their taxes. If the company is not going to rely on venture capital, then it is possible that a Limited Liability Company, or LLC, may provide more favorable tax treatment. In order to determine what model is right for your business, research the different types of businesses instead of deferring to the common practices of others. Discuss your choice with your tax advisor and legal representative.
Once you determine your incorporation strategy, consider incorporating in your home state. Companies choose to incorporate in Delaware for a variety of reasons, but ask yourself – will you need venture capital investment to make your startup successful? If the answer is no, consider starting the company in your home state. If the answer is yes, then filing in Delaware may be beneficial.
Misconception #3: An NDA protects my IP
Many people understand that “NDA” means “non-disclosure agreement,” but do not understand its limitations. The NDA is an agreement that ensures that when one party (the discloser) reveals information to another party (the recipient), the recipient will keep the discloser’s information secret. That’s about it. Of course, co-founders should sign an NDA to protect the startup’s secrets. However, the NDA does not address who owns the inventions, artwork, or other work products created after signing the NDA. If one founder walks away, they can take their contributions with them. What is needed, on top of an NDA, is an invention assignment agreement or clause (as referenced above). So if you hire a contractor to write code for you, the contractor agreement should have an invention assignment clause. This will help ensure that the code they write belongs to your startup and not to your contractor.
Employees can create a new business without relinquishing their ideas to their employers. Entrepreneurs can incorporate in their home state while protecting their intellectual property through savvy contracts. Through research and consultation with legal advisors, a new company can generate novel ideas and products knowing they will be protected.
Laura Norris is an Assistant Clinical Professor of Law, the Director of the Entrepreneurs’ Law Clinic and the Academic Coordinator of the California Program for Entrepreneurship (CAPE) at Santa Clara University.