As I’ve mentioned before, it’s very important for growing companies to comply with securities laws, even during the initial seed and friends and family rounds of financing. The possibility of lawsuits and even fines and other criminal penalties give founders a strong incentive to comply with the law. But there’s another consequence that could result from non-compliant sales of securities: loss of the company’s IP.
Often, co-founders are issued stock or other ownership interest in exchange for a contribution of intellectual property. That issuance of stock is a securities transaction. If it is not done in compliance with the law, the purchaser of the security (in this case the co-founder who contributed the IP) has a right of rescission, which means that he can sue in court to have the deal unwound. In most securities transactions, where stock was issued in exchange for cash, this would simply result in a monetary award of damages. However, if the stock was issued in exchange for intellectual property rights, then a successful lawsuit by the founder who contributed the IP could result in the company losing its rights to its intellectual property, potentially crippling the company.
When could this arise? Certainly a partnership dispute could cause a departing co-founder to institute such a lawsuit to gain additional leverage in his or her departure. If a company is doing very well, then normally, even if the departing partner alleges a securities law violation, the company can simply pay him cash for his shares. But if a rescission action for the securities law violation would result in the loss of mission-critical IP, then the departing shareholder will have an enormous amount of leverage in negotiating his departure. He could extract significantly larger concessions than he otherwise would have been able to if his remedy had simply been to have the cash he put into the company returned. In addition, even if there are no disputes, potential investors doing due diligence on the company may be scared away because of the potential cloud hanging over the company’s most important assets.
Therefore, once again it is important to emphasize that start-ups should not ignore securities laws in their early rounds of financing, or even in transactions with their co-founders. Failing to comply with the law creates a ticking time bomb for a company that can threaten its business in the future.
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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
