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Startup Legal Lessons from the Biography of Steve Jobs (Part 3)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 3 of a multi-part series.  This post discusses trademark issues in selecting a company name.

Selecting the “Apple” Name

Steve Jobs and Steve Wozniak selected the name “Apple Computer” on a ride from the airport to Los Altos.  Jobs was on a “fruitarian” diet and had just visited the “All One Farm” apple farm near Portland (where he used to spend weekends pruning the apple trees and seeking enlightenment).  On one hand, the name Apple Computer would typically be considered to be a strong name from a trademark perspective.  As discussed in this prior post,  the name “Apple” does not, by itself, suggest to the consumer the nature of the underlying business (making computers).  Accordingly, trademark law would consider the name to be arbitrary, and therefore highly distinctive.  Highly distinctive marks, like Apple for computers, receive greater protection under trademark law.

Selecting a name that is eligible for strong trademark protection is only half the battle when considering a company name.  Entrepreneurs should also make sure that their name does not conflict with any existing trademarks.  In the case of Apple Computer, it did.  Apple Corps, was the name of the Beatles holding company.  Apple Corps first sued Apple Computer for trademark infringement in 1978.  The suit settled with Apple Computer paying Apple Corps a modest payment and the parties entering into a “coexistence agreement.”  The Beatles would not produce computer equipment; Apple could not market any music products.

Apple Corps v. Apple (Not Just) Computers

Apple Computer’s business originally focused on “just” computers, but as we all know, it did not always stay that way.  This is a good example of a common mistake made by entrepreneurs, who are often unconcerned with an existing mark similar to their own in a seemingly unrelated field.  The experiences of Apple Computer, however, demonstrate how seemingly unrelated businesses can suddenly become related through changes in technology and business models.

On numerous occasions, Apple Computer sought to incorporate music-related technology or services into its products.  In the late ’80’s, Apple Computer introduced its Musical Digital Interface and in 1991, Apple Computer launched a Mac with the ability to play music files.  Apple Corps sued over both launches resulting in payments of millions of dollars by Apple Computer.  In 2003, Apple Computer launched the iTunes Store, and Apple Corps sued again.  The parties finally resolved these issues in 2007 with Apple Computer paying Apple Corps $500 million to acquire worldwide rights to the mark, and then licensing back Apple Corps the right to use the mark in connection with the Beatles.

While Apple had the resources to withstand these repeated disputes, it would be cost prohibitive for most startups to address a trademark dispute from a well-financed entity like Apple Corps.  While startups can change their brands, this is also cost intensive not only in terms of mechanically changing the brand but also in terms of the lost good will that a startup has built up with customers, investors, and other partners.

Performing a Preliminary Trademark Clearance

To avoid selecting a company or product name that conflicts with existing rights, entrepreneurs should at the very least conduct a preliminary trademark clearance.  The Entrepreneurship Clinic provides this trademark clearance checklist for entrepreneurs to make sure their name does not have any readily apparent conflict with existing marks.  One common misunderstanding among entrepreneurs is that just because a mark is not registered at the U.S. Patent & Trademark Office does not mean that another party does not have rights to that mark.  One can obtain common law trademark rights merely by using a mark in commerce.  Accordingly, even if your chosen company name does not appear on the U.S.P.T.O. trademark database, one also needs to check to see if that mark is nonetheless being used in commerce.  Once a company or product name has been preliminarily cleared, entrepreneurs would be wise to engage a trademark attorney who can perform a more thorough search on commercial databases covering additional registries and sources of information on possible uses of a mark.  While entrepreneurs often relish their status as risk-takers, selecting a company name is one area where taking on risk makes little sense.

 

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Startup Legal Lessons from the Biography of Steve Jobs (Part 2)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 2 of a multi-part series.

This post discusses the scenario of a departing founder.  As explained on page 61 of Isaacson’s biography, within two weeks of organizing Apple, co-founder Ron Wayne made the decision to leave the company.  He sold the entirety of his partnership interest to the other co-founders, Steve Jobs and Steve Wozniak.  Ron Wayne’s motivation to leave Apple was in part due to the personal liability he would take on as a partner in a general partnership (as discussed in Part 1 of this series, Apple was originally organized as a general partnership).

The departure of a startup founder, however, may not always go so smoothly.  It is extremely common for founders to leave startups.  All too often, these founder breakups can be fatal to a startup.  According to Harvard Business School Professor Noam Wasserman, roughly 65% of the failures of high-potential startups are due to “people problems.”

There are well-known mechanisms, however, that make it possible for a startup to survive a founder breakup.  These include:

IP Assignments

All individuals working for a startup should sign documents assigning to the company any intellectual property created by that individual arising from their work for the company.  This is typically accomplished through a Proprietary Information & Invention Assignment Agreement (commonly called a PIIA).  This document should be signed by an individual at the beginning of that individual’s relationship with the startup.  Proper IP assignment language should include the words “hereby assigns,” so that the language will act to automatically transfer IP rights from the individual to the company upon the individual creating that IP.

If the individual has created IP related to the startup’s business prior to entering a formal relationship with the startup (such as a founder who has been working on an idea prior to incorporation), then that individual should also assign to the company that individual’s IP rights already in existence.

Restricted Stock Agreements Implementing Vesting

As discussed in this prior post, vesting refers to a company having the right to repurchase an individual’s equity if that individual’s service terminates.  The company’s repurchase option lapses over time.  Vesting is typically implemented through a Restricted Stock Purchase Agreement (for a corporation) or a Restricted Unit Agreement (for an LLC).

Departing Founder Example

Let’s pretend Departing Founder owns 25% of the common stock in a startup.  Departing Founder has a falling out with his or her co-founders.  Departing Founder has not signed any documents assigning IP to the startup and does not have a vesting schedule in place covering his or her common stock.  Upon Departing Founder leaving the startup, her or she will likely walk away with (at least) joint ownership of any IP to which Departing Founder contributed, and the full 25% of the company’s common stock.  The startup will not have any exclusive rights to the IP jointly-owned with Departing Founder.  In addition, 25% of the company will be dead weight, which will certainly be demoralizing to the remaining team members still working for the startup.  This startup is likely doomed unless it can work out an agreement with the Departing Founder to claw back the IP and equity.

Now let’s pretend the same situation exists with Departing Founder except that proper IP assignments and vesting schedules are in place.  Upon Departing Founder leaving, all IP will remain with the startup.  The Departing Founder walks away with no rights in the startup’s core IP.  Additionally, the startup will have the right to repurchase the unvested portion of Departing Founder’s 25% of the common stock.  For example, if vesting occurred over 4 years with a 1-year cliff, and Departing Founder left just after the 1-year mark, the startup would be able to automatically repurchase 3/4 of the common stock held by Departing Founder.  Departing Founder would remain a shareholder of the company, but only for the 6.25% of vested common stock (1/4 of Departing Founder’s 25% of the company).  The repurchased common stock would return to the company’s pool of authorized but unissued stock.  It would be available to incentivize the remaining workers, or more likely to attract the talent needed to replace Departing Founder.

Release and Termination

If possible, it is also wise to enter into a release and termination agreement with a departing founder.  While Ron Wayne is at peace with the fortune he would have had he not left the company, other departing founders might experience seller’s remorse and make claims against a company whose value skyrockets after a founder leaves.  Ideally, a startup and departing founder will  resolve any possibility that either startup or the departing founder could have any claim against the other in the future.

Returning now to the Apple situation, Ron Wayne desired to return all of his partnership equity to his co-founders.  This is likely an anomaly, though.  As discussed in our prior post in this series, most startup entities will provide limited liability to founders.  Accordingly, most departing founders will not have the threat of unlimited liability (present with a general partnership) to incentivize the departing founder to relinquish their shareholder or member status.  With the proper legal documentation — including IP assignments and equity vesting arrangements — startups can survive the departure of a founder.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 1)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters today, we thought it might be interesting to revisit Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple since its formation in 1976.  We can use these legal issues as a framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 1 of a multi-part series.

While Steve Jobs and Apple are known for thinking differently (as famously depicted in their 1997 “Think Different” ad), as a company, Apple has still encountered some of the same legal decision points common to today’s tech startups.  One example is the early choice of a form of entity for startup ventures.  On page 61 of the Steve Jobs biography, Isaacson explains that Apple’s three original founders — Jobs, Steve Wozniak, and Ron Wayne — established Apple as a general partnership.  Wayne wrote the partnership agreement, allotting 45% of the equity to Jobs, 45% to Wozniak, and 10% to Wayne, and requiring that expenditures over $100 receive approval of 2/3 of the partnership.

There are a few points to make here.  First, documenting these early agreements is a good idea in most cases.  It is important to note that in most states, a general partnership can be formed even without a written agreement.  The Revised Uniform Partnership Act defines a partnership as “an association of persons who carry on as co-owners of a business for profit.”  Therefore, if founders are working together in pursuit of a venture, they may be operating as a general partnership whether they know it or not.

Absent a written agreement, state law is going to dictate the specific equity and governance structure of the partnership.  This would be the same for other forms of entity as well, such as a limited liability company which is going to have an equity and governance structure imposed by state law in the absence of an operating agreement.  It is highly likely that this default equity and governance structure will not reflect what the founders have in mind.  So, put these agreements in writing — like Wayne did.  Unlike Jobs, Wozniak, and Wayne it is also wise to consult an attorney familiar with startups who can also establish industry standard mechanisms such as vesting.

Second, today, selecting to organize a tech startup as a general partnership would be highly irregular.  The reason is that in a general partnership, each partner is responsible for the liabilities of the company (whether or not that partner was involved in any way with the actions underlying the liability).  In other words, an individual partner in a general partnership could incur catastrophic liability through no fault of their own.  Accordingly, almost all tech startups will organize in a form of entity providing limited liability to the owners — typically a limited liability company, an S corporation, or a C corporation.   This prior post addresses the entity selection question for startups.  Indeed, according to its website, Apple incorporated on January 3, 1977, within a year of its initial organization as a partnership.

In fact, the threat of personal liability is one of the reasons for Wayne electing to leave the Apple partnership shortly after its formation.  According to Isaacson’s book, Wayne became worried about his personal liability for Apple’s debts when Jobs began planning to borrow money to grow the company.  He sold the entirety of his partnership interest to Jobs and Wozniak for $2,300, as reported in Isaacson’s book and by Wired Magazine.  We will talk more about legal issues associated with departing founders in our next post in this series.

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A Primer on Vesting

A "vesting schedule" does not refer to the days of the week when you must wear this.

A “vesting schedule” does not refer to the days of the week when you must wear this.

Fred Wilson recently wrote about the natural turnover on startup teams, with frequent references to the concept of “vesting.”  “Vesting” refers to a startup’s right to repurchase an individual’s equity if that individual’s service to the startup terminates.  This repurchase option lapses over time according to a “vesting schedule.” The following are some important points concerning vesting:

Vesting Schedule

Industry standard is to implement a four-year vesting schedule, with a one year “cliff.”  This means that the individual would need to work twelve months in order have the first 25% of his or her equity vest.  After the one year “cliff,” the equity vests on a monthly basis for the remaining 3 years.  The following is standard language implementing this vesting schedule from Orrick’s model Common Stock Purchase Agreement:

100% of the Shares shall initially be subject to the Repurchase Option. 25% of the total number of Shares shall be released from the Repurchase Option on the one year anniversary of the Effective Date, and an additional 1/48 of the total number of Shares shall be released from the Repurchase Option on the 15th day of each month thereafter, until all Shares are released from the Repurchase Option; provided, however, that such scheduled releases from the Repurchase Option shall immediately cease as of the Termination Date. Fractional shares shall be rounded to the nearest whole share.

The rationale behind the cliff is that there should be some minimal amount of service that each individual commits to a startup before they can walk away with any amount of equity.  The cliff can be adjusted, especially in the case of a founder who has devoted significant time to a startup prior to implementing a vesting schedule.  The rationale for equity vesting on a monthly basis after the cliff is to foster natural behavior from employees leaving the company when they desire to do so.  It would be counterproductive to have an individual who no longer desires to work for a startup continue working merely to achieve a future significant vesting milestone.

Repurchase Option

Many people mistakenly assume that with a typical startup vesting arrangement an individual is acquiring equity as it vests.  Actually, in the typical situation, an individual who owns restricted equity owns all of their equity.  For unvested equity, however, the company has an option to repurchase that equity if the individual discontinues service for the startup before that equity vests.  Typically, the startup can repurchase the equity at the same nominal price the individual paid for that equity.  Contrast this with a buy-out of an individual’s vested equity, which will typically require a calculation or agreement upon the fair market value of that equity at the time of the buy-back.

To ease the mechanics of a startup exercising its repurchase option of unvested equity (which might take place after a falling out with the individual when the individual and company are not on speaking terms), it is common for both: (i) the startup to hold unvested equity in escrow, and (ii) for an individual, at the time of purchasing the restricted equity, to sign an assignment of unvested equity back to the company which the company will then sign if it executes its repurchase option at any time.

Triggering the Repurchase Option

It is important to think about what triggers a company’s right to repurchase an individual’s unvested equity.  Typically, a company’s repurchase option kicks in when an individual’s “service” with the company terminates.  Ideally, a company will have at-will relationships with all individuals and a clear governance structure such that an individual’s service can easily and clearly terminate.

Documents

Vesting is typically implemented through a Restricted Stock Purchase Agreement (for c-corps) or through a Restricted Unit Agreement (for LLC’s).  Orrick provides a model Common Stock Purchase Agreement with industry standard vesting language.

83(b) Elections

Remember that a standard vesting arrangement (where the company can repurchase an individual’s equity at the purchase price) means the equity is subject to a substantial risk of forfeiture such that an 83(b) election should be filed.  This prior post addresses 83(b) elections in detail.

As discussed previously on this blog, vesting is a critical part of setting up a healthy and productive environment for the startup team.  The combination of vesting schedules and at-will relationships is what allows a startup to alter its equity allocation if the initial equity distribution does not align with the actual contributions made by each team member.

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IP Strategy: The Difference Between Startups and Large Companies

On some issues, IP strategy for startups as compared to large companies can differ like night and day.

On some issues, IP strategy for startups as compared to large companies can differ like night and day.

It is important for entrepreneurs to understand that IP strategy for a startup may differ significantly from that of a large technology company.  Accordingly, entrepreneurs should make sure their IP counsel is familiar with startups and their unique circumstances.  Here are a few examples of how IP considerations differ between startups and large companies:

Provisional Patents:

Startups are more likely to file provisional patent applications than large companies.  A provisional patent application is a temporary application that can typically be prepared less expensively than a nonprovisional application because it has fewer formal requirements (for example, no claims are required, no formal drawings are required). The applicant must file a nonprovisional application within twelve months of filing the provisional application in order to receive the benefit of the provisional filing date.  A provisional application can avoid problems from publicly disclosing ones invention (because a public disclosure of technology that is adequately described in a filed application will not constitute prior art).

Filing a provisional application, followed by a nonprovisional application will typically cost more than simply filing a nonprovisional application.  This is because there will be some overlap in work by the patent attorney.  Additionally, once a nonprovisional application is filed, the patent examiner will at some point begin reviewing the application, thus leading to additional patent attorney expenses as the patent attorney communicates with the patent examiner.  Therefore, large companies are much more likely to be willing to pay the larger upfront costs of a nonprovisional application and to earlier incur the costs of patent prosecution.  Such companies are more concerned with limiting their total patent expenditures.   Startups, however, may be willing to pay a higher total cost in order to defer the large portion of the expenses by twelve months.  For example, a startup may lack the resources to file a nonprovisional application (which can easily cost $10,000-$15,000 just to prepare and file), and may therefore opt for the less expensive up-front cost of the provisional application (typically costing less than half of a nonprovisional application).  After filing a nonprovisional application, a startup can then seek capital to see if it can finance a more robust patent filing strategy.

Note that while well-prepared provisional patent applications are typically a sound strategy for startups, it is extremely risky to file a “cover-sheet” provisional application (i.e., consisting of a filing cover sheet on top of an existing document such as a slide deck), as discussed in this prior post.  If a provisional application does not adequately describe the invention, future patent claims may not benefit from the filing date of the provisional and may be subject to prior art subsequent to the provisional filing but prior to the nonprovisional filing date.

Competitive Patent Intelligence

Technology companies are often concerned about the threat of willful infringement which can result in a federal judge tripling an infringement damages verdict.  Generally speaking, willful infringement occurs when one knows about a patent and recklessly proceeds to still infringe that patent.  In order to avoid being found to be a willful infringer, some companies might purposefully avoid becoming aware of other patents.  For startups, though, the benefits of knowing about a problematic patent at a point in time when the startup can take corrective action typically far outweigh the relatively small risk of later being found to be a willful infringer.

If a startup learns of a patent that covers its contemplated product or service, the startup can possibly “design around” that patent be altering its product or service in a way that avoids infringing the claims of the problematic patent.  Most startups cannot afford to receive a cease and desist letter (which can scare away investors or other partners), let alone the cost of years of patent litigation.  So, most startups will not survive to get to the point where they have: (1) received a cease and desist letter from a patentee; (2) chosen to litigate the issue and survived years of patent litigation; (3) then have been found to infringe a valid and enforceable claim of that patent and received a damages verdict; and (4) then have been found to be a willful infringer and had the court increase the damages amount up to 3x.  Most startups will not make it past #2 in the above list.

In addition, most early-stage investors will expect a startup to have at least some idea of the  competitive IP landscape and its impact on the startup’s freedom to operate.

Drafting the Written Description

Experienced patent prosecution attorneys will tell you that preparing a good written description is an art.  The attorney first has to adequately describe the invention in a way that satisfies the written description and enablement requirements of section 112 of the patent act.  The attorney also has to avoid using any language that could be used to later narrow the scope of the client’s patent rights.  When a court assesses the scope of a patent claim, the court will read the patent claim in light of the patent’s written description.  If the written description makes clear that a certain aspect of an invention is a critical aspect of the invention, a court might interpret the patent claims to only cover technology having that aspect.  Accordingly, most patent attorneys will seek to cautiously avoid any language that a court could later construe as making any single aspect or embodiment of the invention seem  critical.  This will often result in a vanilla and bland document.  A patent will be in force for twenty years after its nonprovisional filing date, and it is hard to predict what direction the market for the technology will take.  A written description that methodically and plainly describes multiple embodiments without adding much color to the importance of any single feature can often be the best way to maintain the flexibility for the client to later assert that its patent claims cover slight modifications that a competitor makes to the patented technology.

An initial patent for a startup, however, is likely to have a much broader audience than a federal judge in a patent infringement suit.  Long before that patent is ever read by a judge or jury (in the highly unlikely event it is ever subject to a lawsuit), that patent is going to be read by investors, potential partners, and possibly even potential key employees of a startup.  Accordingly, patent counsel for startups may choose to draft a patent application with language highlighting the importance of some of the features of the invention.  The benefits of an investor understanding understanding the novel aspects of an invention covered in a patent application may outweigh the risk of a judge adopting a narrow interpretation of the patent claims down the road.  Also, if a startup is successful with fundraising and selling products to its customers, its first patent application is not likely to be its last.  It can then adopt a more traditional patent drafting strategy in its subsequent patent filings.