TOP LEGAL MISTAKES COMPANIES MAKE AND HOW TO AVOID THEM

The last 12 months have been difficult for most companies. The recent market gyrations have made it difficult for companies to raise capital and attract talented personnel with the lure of cheap stock options.

One of the principal challenges today is for management to favorably position their company to raise capital, whether from venture capital sources or in an initial public offering, as the window reopens.

However, there are common legal mistakes many companies make that detract from their ability to raise capital from private or public sources. These mistakes include:

“Cheap Stock” Problem

Granting low-priced options or restricted stock to employees, commonly referred to as “cheap stock” may help a company attract and retain personnel but can come back to haunt its bottom-line. If the stock options have been issued for below the fair market value, the company will have to record the difference between the fair market value of the underlying stock at the time of the grant and the exercise price as compensation expense. The effect is to lower the company’s earnings and make it less appealing to investors.

The Securities and Exchange Commission (“SEC”) has been very vigilant in the cheap stock area. Therefore, any company that intends to seek venture capital funds or an initial public offering, even if it’s a future option, should carefully plan in advance to guard against this problem.

Solution. Companies can minimize such problems by carefully keeping records of contemporaneous sales of stock to outside parties or if there are no sales having an appraisal done by a valuation expert or investment banking firm of the value of the options at the time they are granted.

If there are no contemporaneous purchases or an appraiser is unfeasible, companies must be ready to explain why there is a significant difference in the value of the stock between the time it was issued and the present price. To accomplish this, management must be able to point to a major event or events such as patent approval, FDA approval, significant increased revenues, new product introductions, etc.

Securities Laws Violations

Most companies require multiple rounds of financing, especially during the early and growth stages. Technical violations of federal and state securities laws can easily occur and create problems with far-reaching consequences. Most companies raising capital from private sources utilize Regulation D of the Securities Act of 1933, which allows companies to offer securities under an exemption from securities registration. Regulation D imposes rigorous conditions on the sale to unaccredited investors (which among other criteria includes individuals who do not have a net worth of $1,000,000 or income in excess of $200,000 in each of the two most consecutive years and reasonable expectation of having the same income in the next year), including extensive disclosure and complex documentation for offerings involving more than $1,000,000 in securities.

Securities law violations can kill an IPO or venture funding. The SEC may require a company with violations to disclose such violations in any offering document, establish reserves in the financial statements or make an offer to shareholders rescinding the sale.

Solution. By selling securities only to accredited investors, companies dramatically decrease their chances of technical securities violations. Investor questionnaires should also be obtained in order to establish the individual investor’s accreditation status prior to a company accepting a subscription to purchase securities. It is important for companies to maintain such questionnaires in their records to evidence investor status.

Failure to Maintain Proper Organizational Records

Another common mistake of emerging companies is the failure to maintain proper records of the company’s equity ownership and organization. A lack of corporate formalities may result in the doctrine of “piercing the corporate veil,” where a court may ignore the corporate status and permit creditors of the company to assert claims directly against the company’s shareholders if it finds that the corporation has been merely an alter ego for the shareholders. Even more problematic for a company is a lack of proper equity ownership records. Confusion over the number of shares outstanding and who owns them can impede or even kill venture funding or an IPO.

Solution. The solution is fairly simple. The company’s minute book should be examined to ensure that it is up-to-date and accurate and any deficiencies cured, including proper documentation for shareholders’ meetings and minutes reflecting board authorization for corporate acts such as the approval of material contracts and the issuance of securities. Meticulous records should be kept of all stock issuances and transfers, and all offers to sell or grant options should be recorded in writing and not oral promises.

Failure to Adopt an Employee Stock-Option Plan

Companies that delay instituting an employee stock-option plan may find it difficult and time-consuming once they have a large, diverse group of shareholders required to approve the plan. What is more important, companies that grant stock options or other equity based compensation without a qualified incentive stock option plan (“ISO”) may impose added tax liability on employees and risk losing significant tax benefits.

In a nutshell, Section 83 of the Internal Revenue code governs the taxation of employees who receive property, such as stock options, in exchange for services. Under Section 83, employees get taxed at the time they exercise the stock option rather than at the time it is granted. The result is the employee is taxed at the rate of ordinary income on the difference between the fair market value of the stock as of the date of exercise and the actual exercise price. Worse yet, the tax is due in the tax year the stock is exercised whether or not the employee sells it.

Solution. By adopting an ISO, pursuant to Sections 421 and 422 of the IRS code, companies can reduce the tax burden to their employees. If certain requirements, too numerous to discuss in this article, are met there are no tax consequences to the employee at the time the stock option is granted or exercised. Instead, the tax on the shares is deferred until they are sold. If the employee holds the shares for at least one year from the date he exercised the option and at least two years from the date the option was granted, the entire gain of the sale will be taxed at the capital gains rate.

Failure to Protect Intellectual Property

It doesn’t matter whether your company is high-tech or a service company – or anything in between -- it has valuable intellectual property that needs to be protected. Intellectual property can range from patents, copyrights, trademarks, servicemarks to trade secrets. Failure to properly protect intellectual property may result in a company losing good title to it.

Solution. To protect its inventions a company should apply for a patent with the U.S. Patent and Trademark Office (“USPTO”). A patent ensures that others cannot use your invention. Additionally, under patent law, the rights to an invention belong to an employee and not the company, even if it was conceived and developed in the course of the employee’s employment. To further protect its patents, companies need to obtain a written assignment from the employee that developed the patent. The same applies for any creative work which should be registered with the Copyright Office of the Library of Congress. Again, intellectual law favors the creator over employers. In order for employers to claim ownership for a copyrighted work, it has to meet the criteria of the work-for-hire doctrine. If the work is done by an independent contractor, the company must obtain a written assignment of the work. Patent or copyright assignments must be for valuable consideration, not just continued employment.

Especially in the new economy, many companies have rushed to register domain names, developed web sites and even distributed products only to find that someone else has the rights to the trademark. Trademarks -- any word, name, symbol or design – can prevent other companies from using the same or confusing similar marks. Companies should conduct a trademark search and register their trademarks with the USPTO prior to using any logo, domain name or other trademark symbol.

Trade secrets, valuable information not generally known, are important corporate assets that need to be protected. Trade secrets can be a specific way a company does business, its customer lists, techniques or almost any other subject matter. However, a company must take reasonable precautions to keep the information secret by limiting access to it. A written policy should be established with standard procedures and practices the company and its employees follow to ensure the information remains confidential.

This article is merely an overview of the major legal problems many companies face and by no means all-inclusive. The subjects discussed above are complex, so companies should consult with their own counsel regarding their specific situation.

Elizabeth Brandon-Brown is an attorney practicing in the areas of securities and corporate law and can be contacted at elizabeth@brandonbrownlaw.com or (561)289-3815.

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