Minnesota Start-Up Darwin Lessons Part 2 Wednesday, October 10, - - PowerPoint PPT Presentation

Minnesota Start-Up Darwin Lessons Part 2

Wednesday, October 10, 2018

Lisa Holter Ankel, Larry Fox and David Peteler Avisen Legal, P.A. 901 Marquette Ave. S. Suite 1675 Minneapolis, MN 55402

If You Give A Mouse A Cookie…

• A Bay Area company in the healthcare space

developing SAS product.

• Three Founders, Equal 1/3 Shareholdings
• Business
• Sales
• Science
• No Vesting or Repurchase
• Sales Founder in Financial Trouble

If You Give A Mouse A Cookie…

Problem: What if the executives leave? Solution:

• 1. We implemented a Shareholders Agreement with vesting schedules

and buy-back provisions on termination.

• 2. We issued the stock in certificate form and set up an escrow to hold

the unvested shares.

• 3. Had all founders sign nondisclosure agreements. This is California,

so non-competes were not an option.

If You Give A Mouse A Cookie…

What went wrong?

• 1. Science founder couldn’t live on a founder’s non-salary, took a job

with a university.

• 2. He continued to provide some level of service, so we restructured

his vesting schedule and let him keep his shares.

If You Give A Mouse A Cookie…

Marketing founder couldn’t live on a founder’s non-salary.

• 1. Constant arguments over why he wasn’t paid out of small change the

Company had.

• 2. Borrowed money from the Business founder.

The note was poorly written and unsecured

• 3. Took $250,000 Company financing as a personal loan secured by his

Company shares.

• Corporate Opportunity Problem
• Corporate Expense – documenting the deal and establishing share escrow
• Bad choice by management to try to keep him happy

If You Give A Mouse A Cookie…

• 4. Sales Founder blew through the $250,000 in a few months.
• 5. Sales Founder left the Company to work full-time for a Company client he

had been assigned to. Diverted the orders of that client to a third party. Company chose not to pursue non-solicitation action.

• 6. Sales Founder filed for bankruptcy.
• a. Claimed that the Company shares he owned were part of his bankruptcy

estate.

• b. Claimed that the security interests in his shares were not perfected.

If You Give A Mouse A Cookie…

All Is Not Lost. What did we do?

1. We assigned the repurchase right to the Sales Founder’s unvested stock to the Business Founder. 2. Business Founder exercised the repurchase right in exchange for cancelling the personal loan. 3. Lender foreclosed on the remaining shares collateralizing his loan 4. We proved the security interests in the collateral were perfected through possession of the stock in the escrows. 5. The Sales Founder was so buried in his bankruptcy he didn’t want to spend money to fight the Company’s actions in court.

If You Give A Mouse A Cookie…

Overall Results:

• 1. Company made concessions to keep the executive
• a. Gave up $250,000 financing – critical
• b. Personal loan from founder
• c. Lost a key customer when the executive left
• 2. Went through time, expense, and aggravation to salvage the situation
• 3. Business Founder repurchased 50% of executive’s stock
• 4. Lender got the rest of the stock as collateral for his note

If You Give A Mouse A Cookie…

Thoughts On This Story

1. If there is a problem executive, it may be best to fire him quickly

“Hire slowly, fire quickly”

2. Be careful about granting concessions and special treatment 3. Don’t allow diversion of financing from company 4. Get your legal documents in order

• a. Shareholder Agreements
• b. Vesting schedule and repurchase rights
• c. Establish escrow for unvested stock
• d. Carefully document loans and transactions
• e. Document employee performance, build file for termination
• f. Have good termination clauses in employment agreements
• g. Consider exercising Company rights quickly and firmly

If You Give A Mouse A Cookie…

Do we really need to take all these precautions and do all these legal documents? Maybe not… But ask yourself…

Ask Yourself – Do You Feel Lucky?

The Merger That Shouldn’t Have Been

• An automobile dealership formed a sister company to set up a separate auto

service facility.

• The newly-formed company did some preliminary work, incurred initial

expenses, then sat dormant. Finally the decision was made not to set up a separate service facility.

• The company’s accountant saw the “abandoned” shell company with losses in

it, and decided to make use of the losses.

The Merger That Shouldn’t Have Been

• The accountant decided to merge the two companies, so the
• perating company could take advantage of the losses of the

abandoned company.

• The accountant filed Articles of Merger with the Secretary of State.

The Articles became effective and the merger was completed.

The Merger That Shouldn’t Have Been

What Was The Problem?

• The accountant called in a panic. He had merged the operating

company into the abandoned company, and out of existence.

• This violated the terms of several key contracts, including:

The dealership franchise The bank loans

The Merger That Shouldn’t Have Been

What Did We Do? I contacted the Secretary of State to “undo” the merger. The duty counsel was concerned that this had never been done before. His analogy: you can’t unscramble two eggs.

The Merger That Shouldn’t Have Been

• I managed to convince the duty counsel that:

 The parties at interest (shareholders of both companies) were the same;  The parties all agreed to reverse the merger;  No third party would be adversely affected by reversing the merger;  No tax return had yet been filed based on the merger, so there was no adverse tax effect.

• The Secretary of State’s office agreed to “unfile” the merger.
• We unscrambled the eggs.

The Merger That Shouldn’t Have Been

The Takeaway?

• Don’t have your accountant do your legal work.
• Call your lawyer.

Golf Gals

• Event manager for professional golf association

decides to go out on her own and form her own event planning business

• She previously worked with a talent

management and marketing agency, and has relationships with former athlete clients

• She brings with her 2 colleagues who have

experience running the events

• They agree to be equal owners
• No agreement regarding compensation, vesting
• r repurchase rights

Golf Gals

What could go wrong?

• Founders didn’t contribute equally to profitability of company
• All business leads and revenue came from 1 founder –

“rainmaker”

• Her compensation wasn’t commensurate with her value
• Her co-founders compensation wasn’t commensurate with their

value – they were replaceable

Golf Gals

Options:

• Discussions didn’t resolve the issue
• No right to buy others’ out of the business
• Rainmaker didn’t want to pay the others to exit a business they

didn’t add any value to

Golf Gals

Solution:

• Dissolve the company
• Loss of goodwill and IP which wasn’t assigned to

any of the founders

• Rainmaker started over

Golf Gals

Lessons Learned:

• Equal isn’t always fair
• Enter into a shareholder agreement with buy-back rights, deadlock
• ptions and/or vesting
• Treat compensation separately from ownership

Ambitious Employee

• Boss Bill heads up Non-profit’s education group
• Bill conceives of software tool to schedule education amongst

universities and industry players

• Bill envisions free use within the education industry for the

tool

• Bill requests and receives coding resources within

Non-profit

• Bill assigns employee Ed to manage the project
• Ed is a business grad and is working on MBA
• Ed sees commercial value in the scheduling tool

Ambitious Employee

What could go wrong?

• Upon completion of his MBA, Ed decides to quit and form his
• wn business to market the scheduling tool
• Ed initially says he has rights in the tool, and requests Non-

profit “confirm” this in writing. Does he?

• Ed then asks for tool to be given to him for no consideration to

continue to develop and market

• Ed requests commitment from Non-profit to be beta site

Ambitious Employee

How should Bill and Non-profit respond?

• Bill wants Ed to succeed
• Non-profit doesn’t see commercial value in the scheduling tool
• Non-profit agrees to grant ownership rights to Ed, subject to:
• Non-profit’s retention of its ownership in the tool
• Non-profit’s right (but not obligation) to be a beta site
• Ed will offer Non-profit any improvements that Ed makes

Ambitious Employee

What happens next?

• Ed requests Non-profit become a beta site, Non-profit declines
• Ed finds another company to be the beta site
• Ed raises money from outside investors
• Non-profit continues the development of the tool Ed’s company

sends a cease and desist letter to Non-profit to stop it from making improvements, claiming breach of the agreement. Is there a breach?

Ambitious Employee

Lessons Learned:

• Ed’s tactics from the outset were suspect, should have led to

heightened scrutiny

• Non-profit’s corporate culture – free use of tool; wanting

employee to be successful – restrained it from heavily negotiating the deal

• Was it fair for Ed to get ownership rights to a software tool for

free?

• Simple and friendly agreement could have been more detailed,

noting all the rights Non-profit retained

Arrogance and Greed

• Professional services firm with 20+ owners in Minnesota
• Partnership agreement noncompete provisions were not enforced in

arbitration against a former employee who went to work for a competitor – too vague

• Firm revised its partnership agreement and all partners signed it
• Non-compete prohibited owners from rendering any of the 112

services (as specifically listed in the non-compete) that Firm provides to any client that was serviced by Firm during the two years prior to departure

• tied compliance with the non-compete to receipt
• f retirement payments over a 10-year period

Arrogance and Greed

• Years later, Firm again desired to revise its partnership agreement
• Reduced the amount of deferred compensation for retiring owners
• Updated the non-compete, to be a non-solicit which is less

restrictive, but more enforceable under MN law

• Founder would retire soon - Firm offers to grandfather in Founder for

deferred compensation

• Founder is upset about changes, Firm postpones adoption until

Founder retires

Arrogance and Greed

What could go wrong?

• Founder retires
• Founder elects to continue working on small projects for 3 of

Firm’s clients from Florida

• Firm sues Founder for breach of non-compete
• Founder claims non-compete is not enforceable
• overly broad in scope and duration
• remedies in agreement – forfeiture of deferred compensation,

damages of 25% of revenue – are disproportionate to harm

Arrogance and Greed

Court upholds non-compete

• All partners, including Founder, signed the partnership agreement with

the non-compete

• Founder had been instrumental in revising the language from earlier

noncompete

• Reasonable to protect Firm’s legitimate business interests, including

customer goodwill and confidential information

• Founder had built “strong and longstanding relationships with many

clients” and had access to confidential information in his former position as administrative partner and a member of the Firm’s executive committee

Arrogance and Greed

• 10-year period of the non-compete was reasonable, because the

nature and extent of Founder’s client relationships was so great that it would take years for a different Firm partner to assume the same level of trust that Founder had with these clients

• $2.4 million judgment against Founder for past and future damages

to Firm’s client relationships

• Founder must pay Firm 25% of all revenue received for both past and

future work (as required by the non-compete)

• Firm relieved of its obligation to make any remaining retirement

payments

Time Served

• Company is strapped for cash
• Founder has self funded product
• Founder is looking for sales assistance
• Founder brings on sales person on a “trial basis” who has no prior sales

experience, but has other relevant experience

• Oral Agreement
• Sales Person Works for No Pay Over Summer
• If it “Works Out” Sales Person Will Be Hired in Fall at Agreed Salary and Maybe Get

Some Equity

• Sales Person is given a title of Vice President and represents Company

globally

Time Served

What Could Go Wrong?

• Company Makes Offer at the End of the Summer
• Agreed Salary, but No Equity
• “Employee” Heavily Negotiates Offer
• Company Withdraws Offer
• “Employee” Demands 3 Months’ Salary and Equity For “Time

Served”

• “Employee” Threatens Suit for Unpaid Wages and Attorneys’ Fees

pursuant to MN Statute Requiring Prompt Wage Payment

• Company Makes Payment to “Employee” to Settle Matter and

Incurs Unanticipated Legal Fees

Time Served

Lessons Learned

• Document Terms of Employment, Even if Unpaid
• Be Careful About Having Employees Work Unpaid, Including Interns
• Comply with Wage and Hour Laws
• Be Careful About Offering Potential Equity to People You Do Not Know
• Before You Make an Offer, Assess Performance
• Better to Hire People with the Experience and Skills You Need and Pay Them

Cash or Equity Than Hire Someone With No Experience at a Low Cost and Hope they Grow Into the Job.

Et tu Brute?

• Company Provides Online Classes for a Fee
• Consultants Develop Content
• No Assignment of Content to Company by Consultants
• Company Consists of Founder and One Employee
• Employee Leaves
• Employee Develops Competing Business
• Competing Business Has Similar Content
• Company Has no Claim Against Competing Business

Et Tu Brute?

Lessons Learned

• Get Non-Competes in Place with Your Key Employees Before They Start
• Get a Written Agreement From Consultants to Assign to Company Rights in

Content They Develop

Founder’s Dilemma

• Renewable Energy Project Development Firm
• Founder is President and CEO of General Partner
• General Partner Develops Projects
• Limited Partners Provide Money for Renewable Energy Projects
• Venture Firm and Individual Investor Provide Funding to General

Partner

• On Funding, Board Expanded to 3: Founder, Individual Investor and

VC Firm

• Investors get Majority of Shares

Founder’s Dilemma

Things Go South

• GP Runs Out of Money
• President of GP takes out a Loan, Using LP Assets as Collateral, Which

Violates LP Agreement

• CFO and Lawyer Lock President out of the Office
• Board Fires Founder as President
• President Sues Company for Wrongful Termination
• Company Ceases Operations and Remaining Funds are Returned to

the Limited Partners

Founder’s Dilemma

Lesson Learned

• Founders Can be Replaced if They Give Up Control
• If You Do Not Want to be Replaced:
• Be Careful About Giving Up Majority Control or Board Control.
• Negotiate a For Cause Termination in Your Employment Agreement
• Even though no actual harm was caused by using the LP Assets as Collateral, it

was improper and therefore sufficient to justify the termination.

• Don’t Ever Use Investor Money for Unauthorized Purposes

Questions?

Lisa Holter Ankel lholterankel@avisenlegal.com Larry Fox lfoxavisenlegal.com David Peteler dpeteler@avisenlegal.com