Space (and) The Final Frontier

Part 5 in a series in Startup Stages

In this post, we deal with the last two pre-institutional funding risk triggers.

Leasing Space
One mistake startups make is leasing dedicated space too soon. In some cases this is unavoidable (e.g. if you are a manufacturing company handling hazardous materials or requiring heavy equipment). But for software, Internet, or light hardware development, there may be more cost effective options.

Leasing can add considerably to the cash burn, administrative overhead, and risk of a startup. While the NNN lease rate may be low, required insurances, taxes, utilities, common area expenses, and maintenance can easily double the rate. In addition, landlords often require multi-year (3-5) agreements with security deposits, tying up or committing limited cash.

On top of this, there are upfront costs associated with tenant improvements, furnishing, and permits.

New compliance issues include:

• Local fire department regulations/ inspections
• Insurance policies: property and liability ($1-3 million policy coverage required by most landlords)
• Worker health and safety including evacuation plans, notice postings
• Special operating permits depending on the nature of the business (e.g. environmental, hazardous materials)

Additional overhead:

• Utilities (electric, gas, water, janitorial, alarm service)
• Facility maintenance and repair (don’t assume the landlord covers it)
• Facility safety

Really think through whether you need to lease space. While employees create value, furniture does not.  If you must lease space, take a look at which employees really need to be physically co-located and which do not. (It’s amazing how space efficient a person with a laptop, Wi-Fi and a cell phone can be.)

As an alternative, consider hosted office space (also called executive offices). While at first glance, base lease rates are more expensive than dedicated space, total operating costs may actually be cheaper. Hosted offices usually come fully furnished with utilities, are available on one year or shorter leases, don’t require insurance, and have a range of amenities including kitchens, meeting rooms rentable by the hour, office equipment charged on a per use basis, and reception desk services.  Just watch the notice period requirements for cancellation; they can be as long as three months!

The Final Frontier:  Accepting Customer Purchase Orders
Congratulations! You're no longer pre-revenue; you’ve closed your first sale! The P.O. or contract just hit your email… and with it a new set of legal obligations.

A purchase order is a legally binding contract and by its acceptance, the startup is obligated to perform in accordance with the terms and conditions negotiated. In addition to price and delivery, terms to be negotiated should include:

• Product or service acceptance criteria (specifications to be complied with or other conditions that allow closing of the contract and subsequent invoicing)
• Warranty terms, indemnities, and other liabilities
• Damage exclusions
• Title risk transfer
• Payment terms

In order to avoid reinventing the wheel for each contract, the startup should have its own standard sales T’s and C’s covering these. If the startup doesn’t furnish its own T’s and C’s, it could inadvertently end up agreeing to the customer’s T’s and C’s.

Assuming the startup has the associated operational infrastructure for sales order processing, development, production, quality control, and shipping, the additional administrative overhead required includes:

• Sales terms and conditions
• Accounts receivable, invoicing, and collections
• Insurance policies: product liability and/or errors & omissions (services)

If the startup uses distributors or sales representatives, it will also need the appropriate agreements defining the commercial relationship.

Next and final post in the series:  Dealing With It

The BIG Risk Trigger: Hiring

Part 4 in a series in Startup Stages

The hiring of employees is probably the most significant compliance and risk trigger for a startup, (especially in the State of California). This includes the case where the founders are placing themselves on the payroll as employees, rather than compensating themselves as partners. Beyond the risk issue, to attract and retain employees, the startup may need to offer benefits and stock incentives, each of which has its own set of compliance issues.

Knowing this, some startups try to minimize their employer obligations by treating everyone as independent contractors. Unfortunately, Federal and state laws restrict the degree to which this can be done and businesses that run afoul of these guidelines can find themselves owing serious back taxes, benefits, and penalties.  (See my prior post on this subject.)

Compliance requirements now include:

• State of California EDD (or equivalent) Filings:  DE-1, DE-34, and Employer Account Number
• Federal and state laws governing wages and hours, discrimination, and wrongful termination
• Federal and state withholdings for various payroll taxes
• Worker’s compensation insurance coverage (mandatory in California, different by state)
• Benefits provider rules
• Federal and state securities laws with respect to stock options and/or restricted stock grants

(A detailed discussion of employment law compliance is beyond the scope of this blog post.)

The step up in administrative overhead can be quite significant. New policies and processes need to be put into place to ensure compliance, manage risk, and lower insurance costs. These include:

• Payroll and taxes
• Personnel management policies and procedures covering hiring, evaluation, retention, and termination
• “At Will” offer letters or employment contracts
• Worker health and safety
• Insurance policies: worker’s comp, employment practices, general liability
• Benefits administration
• Stock option/restricted stock grant program
• Intellectual property protection (see earlier post)

Of these, payroll and taxes can be readily outsourced, with a wide range of third party payroll processing services available. With respect to the art of managing a workforce, the best generic risk management advice is: think once, twice, thrice before hiring and do the reference & background checks! Believe it or not, there is one thing worse than not filling a critical vacancy and that is filling it with a problem employee.

Firing is not fun.

Next post:  Space!

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups
Startup Stage:  Buying Stuff and Independent Contractors

Startup Stage: Buying Stuff and Independent Contractors

Part 3 in a series in Startup Stages

So you think the purchasing of products and services from is straight forward?  While generally true of the former, the hiring of services, particularly that favorite of all startups, the independent contractor, can expose the startup to significant liability.  Let's take a look at the issues surrounding third party purchases by the startup.

Purchasing by the Business of Products and Services from Third Parties
Once a business entity exists, the founders need to shift the purchasing of supplies, equipment, and services from their personal accounts to the business, in order to take advantage of the limited liability benefit.  Keep in mind that goods and services paid for by the founders (i.e. via personal credit card) do not automatically belong to the business.  They must be transferred in.  The easiest way to do this is via some form of expense reimbursement policy.

Still assuming no employees at this stage, three additional compliance issues must be met:

• Ensuring that independent contractors (if any) are not de-facto employees under Federal or state work rules.  Just because your service provider is willing to be an independent contractor, does not necessarily make it so.  The government has a say in this.  (For more details, see my post.)
• For tax purposes, properly classifying inventory, depreciable assets, and expense items
• Obtaining a state resale certificate in order to avoid paying sales tax on items purchased for resale

In terms of risk management, overhead necessarily increases and involves:

• Executing independent contractor agreements with contractors
• Filing/issuance of IRS 1099-MISC and California EDD DE-542 forms or your state's equivalent (if independent contractors)
• Setting up a business checking account
• Creating accounting controls with respect to purchasing, expense reimbursement, and payables to reduce the risk of fraud and monitor cash burn
• Establishing purchasing terms & conditions
• Obtaining personal property and casualty insurance (if there is a high value to inventory or capital assets)
• Protecting intellectual property (see last post)

For the hiring of services, a well written independent contractor agreement is key. At a minimum, it should (a) define contractor status, (b) assign to the business any intellectual property the contractor creates, (c) spell out contractor responsibility for withholding taxes and insurance, and (d) define the financial terms of the relationship.

Personal property insurance may not make sense unless the startup has expensive capital assets or a high value of inventory (both of which the startup should ideally avoid by outsourcing or building to order).The same goes for establishing purchasing terms and conditions (“T’s and C’s”), although unlike insurance, this costs almost nothing to set up. Having your own set of purchasing T’s and C’s will ensure that you are not inadvertently agreeing to the vendor’s T’s and C’s.

Next post:  The BIG Risk Trigger:  Hiring.

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups

Intellectual Property Creation and Startups

Part 2 in a series in Startup Stages

The underpinning of most technology based startups is the creation of intellectual property (“IP”) in the form of patents, trademarks, and trade secrets (including proprietary designs, software, process recipes, etc.). Yet surprisingly, many technology startups manage this poorly. Management must be diligent in avoiding IP risks, which include:

• Loss of IP rights through failure to obtain proper assignments
• Loss of IP rights through failure to adopt or enforce a lab notebook policy
• Disclosing too much proprietary information in provisional patent applications
• Loss of trade secret rights and foreign patent filing rights through disclosure of the startup’s secrets without an effective non-disclosure agreement
• Breach of non-disclosure obligations through disclosure of a third party’s trade secrets to outsiders
• Misappropriation of the trade secrets of others, especially prior employers
• Infringement of patents and trademarks owned by others
• Having to change the name of the company or its products after brand equity has been built up, due to trademark infringement

The administrative overhead required to manage these risks include:

• Non-disclosure and invention assignment agreements and the associated business processes for their execution and tracking
• Business process for the keeping of lab notebooks, mining of patentable inventions, review of invention disclosures, and filing and prosecution of patent applications
• Employee education regarding the creation and protection of intellectual property
• Patent “clearance” searches prior to significant investment in new products
• Trademark searches to ensure that company and product names do not infringe the trademarks of others

Because trade secret law requires that the owner protect the confidentiality of its trade secrets, it is particularly important to have non-disclosure agreements in place before discussions with key vendors, independent contractors, and employees. In the case of vendors and contractors doing custom work, those vendors and contractors should execute, in advance, agreements assigning to the company any IP they create in connection with their engagement. Don’t assume that because you paid an engineering design firm to do contract work for you that you own it; you’d be surprised what the fine print might say.

A Cautionary Note About NDAs
Did you know that signing a mutual non-disclosure agreement can potentially:

• Impair your ability to commercialize your own inventions?
• If used indiscriminately, impair your ability to claim trade secret status for your legitimate trade secrets?

To minimize this risk, be selective with whom you sign NDA’s and use one-way non-disclosure agreements where possible.  For more about the ins, the outs, and the limitations of NDAs, see my post on What Every Entrepreneur Should Know About NDAs.

So what's the best way to deal with these issues?  If intellectual property is an important element of your startup, hire a good lawyer.  This is not the place to pinch pennies nor does it necessarily mean using one of the big law firms.  Look for an intelletual property lawyer with domain expertise in your technology area.

At this stage of the startup’s life, the compliance and risk management issues are relatively straightforward to manage. However, these escalate significantly in terms of complexity and downside risk as the business begins to issue contracts and hire people.

Next post:  Purchasing Goods, Services, and the Thorny Issue of Independent Contractors.

Related posts in this series:
The "Nitty Gritty" of Startup Formation