Strictly Business

Recycling is generally considered a good thing when it comes to trash.  It helps the environment and conserves resources.  However, in the context of legal work, it is not such a good thing.  Of course, when I use the word “recycle,” I don’t mean recycling the paper that the legal documents are on.  I’m talking about recycling the actual words on the page.  When a client “recycles” their lawyer’s work which was performed on a previous deal and uses it in a new deal, the client is asking for trouble.

Let’s look at a hypothetical example: The founder of a startup has some friends and family invest in the seed round of the company, issuing stock to the investors.  He hires a lawyer to draft the documents and offering materials.  The work is done correctly and the offering of stock is completed without a hitch, and rather importantly, carried out in compliance with securities laws.  The lawyer’s bill came in at $5,000 and the founder is not exactly happy about it (it’s just for “paperwork” after all!), but he begrudgingly pays it.

A year later, the company is running out of money and needs to raise more capital, perhaps this time from a few angel investors.  The founder thinks to himself: “I’m in luck, since I have the documents from our last stock offering, I have what I need and I can simply recycle the old documents.  That way I won’t have to pay the bloodsucking (or some other expletive) lawyers to charge me more exorbitant fees for more paperwork.  It’s just changing the date on the form for heaven’s sake.”

So that’s what he does.  He takes the old documents, changes the dates and the names of the investors and takes in the new investment.  Unfortunately for him and the company, the capital raise is not done in compliance with securities law, causing the offering to be considered an unlawful sale of an unregistered security.  In addition, because the disclosure is a year old, certain events from the past year which would be considered material information are omitted, resulting in a potential securities fraud claim against the company and the founder.  Finally, because provisions in a previous buy-sell agreement or subscription agreement relating to rights of first refusal and preemptive rights are not complied with, there is a dispute as to whether the stock was validly issued.

These kinds of defects have real world consequences.  When securities laws are violated, investors essentially have a “put” option against the founder; that is, if the company fails and the stock is worthless, they can sell it back to the founder and go to court to force him to pay them.  In addition, the SEC and state securities regulators can bring an enforcement action against the founder.  The confusion over whether the stock was validly issued could result in expensive litigation for the company at a later stage, as competing groups of shareholders dispute the ownership of the company.  Even if none of these things happen, and the company continues to grow, if the company were to later seek VC or institutional funding or engage in an IPO, the due diligence will reveal the problems.   At this point, the VC fund or underwriter will either (a) force the founder to pay the VC fund’s lawyers (at high NY rates like $1,000 per hour) to painstakingly clean up the violations or (b) pass on the deal altogether.

The above story is hypothetical, but similar real life examples happen all of the time.  A startup may save some money upfront by doing its own legal work, but the costs down the line will usually end up much higher.  Therefore, trying to draft your own legal documents based on prior work by an attorney ends up being penny-wise and pound-foolish.

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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.

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 a 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.