The Legal Dos and Don’ts of Building Your Team
Ready to make your first hire? Here are 4 things to consider before handing over a contract.
This post is part of “A Rough Draft of the Legal Basics,” a series covering the legal basics every startup needs to cover.
By: Josh Rottner & Pat Mitchell, Cooley LLP
Your company is formed, you and your founders have issued your initial equity and you’re ready to start building out your team. What are the key steps to consider?
1. Make sure that your company owns the IP that it hired its employees and consultants to create
First time founders often assume that if the company hires an employee and pays the employee’s salary, then the employee’s work product is the Company’s property. As we previewed in Part 3, often the opposite is actually true — without a contractual assignment or certain special circumstances, intellectual property is generally owned by the person that invented it, even if the person conceived of the invention or reduced it to practice in the course of his or her employment. Imagine how problematic this could become if you hire computer programmers or software engineers to develop your company’s app, website or other product, and then later on discover that a former employee, not the company, owns the rights to the intellectual property underlying the product!
Luckily, there’s a simple solution: to have all employees sign an agreement expressly granting the company all of his or her rights in intellectual property that they develop while they’re employed with the company. For employees, this is part of an agreement commonly used in the startup community called a Confidential Information and Inventions Assignment Agreement, or CIIAA. We generally recommend including CIIAAs with each offer letter, and requiring that all new employees sign a CIIAA as a condition to their employment. In addition to assigning intellectual property to the company, a good CIIAA will ensure that employees keep the company’s proprietary information confidential, and often also include non-competition and non-solicitation provisions. For an overview of the terms included in CIIAAs on CooleyGo, please see The ABCs of CIIAAs: Protecting Employee Generated IP. In addition, you can generate your own CIIAA through CooleyGo at: Form of Employee Confidential Information and Inventions Assignment Agreement.
Similarly, companies need to ensure that all independent contractors, consultants, advisors, and each other person that does any work at all for the company enter into written agreements expressly assigning the person’s rights in the work that they create to the company. You can generate simple forms of Advisor Agreements and Consulting Agreements containing this language through CooleyGo at: Form of Advisor Agreement and Form of Consulting Agreement.
Finally, since you’ll likely draw on people with experience in the same industry to build your team, understand that they likely signed CIIAAs or similar agreements with their prior employers. This means that as you select your candidates, you’ll need to understand what’s in these agreements to make sure that their prior employer doesn’t own the rights to the work that you want them to do for your company and that they don’t otherwise contain terms that could limit their ability to work for your company (such as a non-compete that covers your company).
2. Remember that employers need to pay at least minimum wage and comply with other federal and state employment laws
Often startup companies have limited cash resources and want to pay employees with equity or other incentives rather than cash. Even if the employee agrees to it, this arrangement may violate wage and hours laws, exposing the company to liability for damages, penalties, etc. While some (but not all) states have narrow exceptions for individuals that own such a significant portion of the equity that they can truly be considered to “own” the business, generally a company should expect that it will need to pay at least minimum wage to its employees in cash, and that its employees will be subject to all of the normal workplace laws and regulations regarding employment and benefits.
On a related point, note that these employment law requirements can’t be avoided by simply calling a person a “consultant” (or “independent contractor”), entering into a consulting agreement and issuing them an IRS Form 1099 rather than Form W-2. Instead, federal and state agencies generally look to the substance of the person’s relationship with a company to determine whether a service provider is properly classified as an employee or independent contractor. Since employers can be liable for tax withholding, back wages, benefits and other penalties for non-compliance with laws applicable to employees, in grey areas it may be preferable to treat a service provider as an employee rather than a consultant.
For other help in complying with employment laws, the U.S. small business administration maintains a helpful website here: https://www.sba.gov/content/hire-your-first-employee.
3. Incentivizing Your Team with Equity
Startups generally want to grant equity to their employees, consultants, advisors and other service providers for a number of reasons, including to compensate them without depleting the company’s short term cash resources and to align their interests with those of the founders. There are a lot of tax and other considerations to consider when issuing equity incentives, so in the future we’ll devote an entire post to these issues, but in the near term founders should understand a few basics:
- Once the company is formed and starts to operate its business, the value of the company increases quickly. For tax reasons, after this increase in value it’s generally easier to issue options to your team rather than stock. With options, the recipient doesn’t have to pay for the equity, and if the exercise price is set correctly, they won’t have any tax impact when he or she receives the option grant.
- Before granting an option, the company should obtain an independent valuation of the company’s common stock that complies with Section 409A of the Internal Revenue Code and related regulations. Without going too deeply into the details of a complex topic, founders should know that Section 409A can impose significant penalty taxes if an option’s exercise price is set at less than the fair market value of the company’s common stock, so it’s important to obtain an independent valuation that complies with the tax rules. The board will then use this valuation to appropriately set the exercise price and avoid causing tax problems for both the company and the recipient. This may mean that the company needs to delay issuing equity until an independent valuation is obtained.
- The company’s board of directors needs to formally approve each equity issuance. This means that equity can only be issued at a validly convened board meeting or in an action by unanimous written consent (note that this doesn’t only apply to equity issued to employees and consultants, but to all issuances of equity, including the founders’ shares). Sometimes founders forget this and commit to issuing equity in other circumstances (such as in employment agreements), which can become problematic if the board of directors isn’t in agreement with what was promised by a particular founder. Other times proper board approval isn’t well documented, which can cause problems down the road when an investor conducts legal due diligence in connection with a financing.
- To easily grant equity to employees and consultants going forward, we recommend that the board and the stockholders adopt an equity incentive plan that takes advantage of certain provisions of the tax code and streamlines the equity issuance process. This way, the company will have standardized processes and documentation ready that makes the equity grant process much more efficient than handling it on a one-off basis each time.
4. Make sure that all service relationships are covered by a written agreement, entered into before the person starts working for your company
This ensures that both you and your new employee or consultant agree on what services will be provided and what the company will give them in return. It sounds simple, but many disputes arise because parties had differing recollections of what was agreed and a written agreement avoids this problem. Simple forms of offer letters (for employees) and independent contractor agreements (for consultants) can be generated through CooleyGo at: Form of Employee Offer Letter and Form of Consulting Agreement.
Background of the series “A Rough Draft of the Legal Basics”
As start-up lawyers, we spend our days working with talented, passionate and courageous entrepreneurs creating cool things. Our clients are on the cutting edge of software, social media, energy, ecommerce, robotics and space exploration. As companies mature, they face a variety of legal issues depending on their industry, strategy and stage of development. But at the very beginning, almost all start-up clients have similar legal needs and tend to ask the same questions. We have advised many companies (including some in the Rough Draft program) on these basic legal questions, and will be sharing our answers with the Rough Draft community in a series of posts on this site. This is part 4 in the series. Click below for previous installments:
