Do you want investors for your company? One of the most basic questions you will need to answer is ‘do you own what you are selling’?
Many entrepreneurs don’t even think about this question. ‘Our company has been building this software for the past two years, of course we own it.’ And yet, experienced investors will have seen many times when this isn’t the case.
Here are the common mistakes founders make on ownership, and how to fix them.
Did your employees and contractors all sign contracts?
This is a common mistake. It’s easy to postpone, because in a small company nobody is really responsible for the legal stuff, legal paperwork seems expensive, and you just want to get to work [helping you deal with this, so you can get back to work, is one thing our firm does]. Why does it matter?
Companies hire people to work on their product or service, e.g., their software. Who owns the end product of the work depends on the agreement between the company on the person. A standard agreement with an employee is that the work is ‘work for hire’, where the company owns all of it.
However, it is also possible to have an agreement where a contractor brings special knowledge to the table, which they keep ownership of, and they grant only a tightly limited license to the company. Or maybe they do the work, but anything patentable that shows up is owned by them as the inventor, and they don’t transfer the patent rights to you.
If you don’t have a signed contract, then nobody can prove what kind of agreement you have. Did the employee or contractor transfer all rights to the company or not? Nobody knows. Nobody can prove anything. Now you’re in a confusing gray zone where certain laws may or may not apply, email records matter, and a court room is looming in the background with uncertain results for everyone. The sort of gray zone that allows you to be sued very easily.
This gray zone means your company may not own the product. So the investor is buying a piece of a company that may not own its product.
Smart investors don’t do this.
Did you pay all your employees … and interns?
Even if you have contracts with all your employees or contractors, you have to be certain you held up your side of the bargain. The contract will typically state that you have an obligation to pay them, in return for which you own their work product.
What if you didn’t pay them? You may not own the work.
This may seem fairly obvious. And yet I have seen many examples where early stage ex-employees weren’t paid everything they are owed.
Cash is tight in early stage companies. It is common to run out before the end of the month. The temptation then is to not pay your employees. One month of back pay stretches into two, and it gets harder and harder to pay, and finally the employee leaves – often with some bad will and almost certainly without signing any sort of severance letter (another important piece of paper).
Or maybe you paid them cash, but you also promised them some options, and never did the paperwork for those options. Now they’ve left and you feel they don’t deserve the options because you would have put vesting in the option grant you would have given them if you ever got around to it. That’s not what they remember. In their world, they were promised options and never got them, and they have the email to prove it.
What happens if you subsequently raise funding, grow the business and sell for $50M? You may face a lawsuit from this upset, unpaid employee who feels that you unfairly profited by taking advantage of his work without paying him everything you promised. Then you’re spending your profits on lawyers, not (as a VC) giving it back to limited partners.
Interns are also worth considering. I have written in the past about the advantages of paying interns. And an internship normally involves a trade of free labor in return for training. It is very possible, especially with courts evolving in this area, that the intern can try to claim that the training wasn’t received, so therefore the contract is invalid (of course if you don’t have a contract, you are in trouble, period).
Are you using technology or a team out of a university?
Universities often get their employees, e.g., the professors, to sign paperwork that transfers partial ownership rights of any invention to the university. If your company is built on work that any team member has done at a university, the university may have partial rights to it.
If the university doesn’t transfer their rights to your company, your company may not fully own the technology you are developing.
If anyone is involved in a university, make sure you verify ownership and get this transfer done. Note that this transfer can be a multi-month process, as you get the necessary approvals from different departments. So start as soon as possible.
Your investor will be sure to ask to see this paperwork if you even mention the word ‘university’.
Did everyone sign off on patent transfer agreements?
A good employment agreement will include a transfer of all patent rights from the employee to the employer. In theory you are covered in all cases. And there are practical matters involved.
I was involved with one company where a new CEO decided to fire the CTO with no warning and no severance payment (as a precursor to a planned bankruptcy and purchase of the company’s assets out of receivership). As the previous CEO I had made sure that a good solid employment agreement was in place, such that the company owned all the patents developed by the CTO.
And yet, as you can imagine, the CTO was quite upset. The default case is that all patents are owned by the inventor, who must sign paperwork to specifically transfer the patent ownership to the company. Practically, you need to get that signature, and compelling signatures through the courts from someone who has no desire to cooperate with you is an expensive, annoying headache. Get all this paper signed while you still have a good relationship.
Did you register all your patents?
In the example given above, when the CTO walked out the door, he – and the company – also knew about three new patentable inventions. The company had never arranged for him to file these patents. It was one of the jobs that kept being deferred.
Even though the inventions were made during his time at the company, and the company knew about them, it was now impossible for the company to file the patents for practical reasons. At least it is possible to legally compel a signature. How do you compel cooperation in the writing of the patent with an unwilling counterparty, who has specialized knowledge that you don’t? The company could have sued to get ownership of the patent if the ex-CTO filed the patent for himself. But he simply didn’t file. Why should he?
Those patents, on key components of the company’s technology, were lost because they were never filed. And the company lost possible ownership of this part of its product.
Did you respect the terms of any open source licenses?
There has been a revolution in software in the past decade, that makes it easier and easier to write complex pieces of code by assembling a series of open source components. If you use these components, you will do so under an open source license. And if you breach the specific terms of the license you use, your ownership rights can be in question.
Most smart programmers know what these terms are and will follow the rules. And investors may want to check on your compliance with these, and with any other licenses you may operate under.
Did you consult your lawyer?
I’m not a lawyer myself. I’ve just seen a lot of things go wrong with company ownership rights, as has any experienced founder or CEO. One of the things a good corporate lawyer will do is tell you what you need to have in place to make sure you have full ownership of your product.
The bottom line
Many deals fall apart between the initial great first investor-entrepreneur meeting, and the writing of the cheque. They fall apart during the dreaded ‘due diligence’ phase. Why? One common reason is the investor checks to see if the company owns its product, discovers ownership is in question, and decides to walk away.
Make sure this doesn’t happen to you. Do things right, now, at the beginning, when you are first creating the product or service.
Make sure you fully own it. Others will check later.