COUNSELING START-UP HIGH TECHNOLOGY COMPANIES

By W. Raymond Felton, Esq.

This article summarizes the presentation given by Randi Friedman, Esq. and the author at the First Annual Business
Law Symposium on October 13, 2000. Given the time limitations in the seminar and the space limitations here, this is an
extremely cursory overview of a topic that encompasses a large number of legal issues. We broke down the discussion
into five parts: (i) a general overview, (ii) protection of intellectual property, (iii) creation of websites, (iv) employment
relationships and compensation issues, and (v) venture capital financing. This article follows the same outline. We were
joined by Alan Goldman, an investment banker, who shared some insightful comments on how investors review and
evaluate these companies.

Overview

We began with a discussion of the so-called new economy and how it differs, if at all, from the old economy. My personal
view is that, at least from a legal perspective, the changes are not as dramatic as some have suggested. For example,
protection of intellectual property and trade secrets, non-competition agreements, licensing agreements, stock options
and venture capital are not things that were created to deal with the internet, and they have a long history of presenting
day-to-day issues for the business lawyer. Nevertheless, there are some differences. There is certainly an increased
awareness and emphasis on these matters on the part of high-tech clients, who tend to be more sophisticated about these
topics compared to budding entrepreneurs of just a decade or so ago. They certainly expect quicker responses and
turnaround than old economy types might have, and they tend to need these matters dealt with at an earlier stage in their
development than their predecessors. Of course, there are some issues that are new, such as website development and
domain name protection. Nevertheless, established principles of contract law, employment law and the like continue to
apply.

As in any new business, the choice of entity and the jurisdiction of formation are issues to be addressed at the outset.
While limited liability companies offer a variety of advantages, the corporation is still the vehicle of choice for venture
capital investors, so it is still commonly used by start-ups that expect to raise capital in that manner. Furthermore, the
corporate form is virtually a requirement for companies to have an initial public offering. While an LLC can be converted
to a corporation via a merger relatively easily, many start-ups choose to incorporate at the outset.

A related question is the state in which to form the entity. For a New Jersey based business, this typically means a choice
between New Jersey and Delaware. There are differences between the two states' laws, but not nearly as many as one
might think when listening to certain Delaware proponents. Nevertheless, because of a decided preference for Delaware
on the part of venture capital investors and their lawyers, and to a lesser extent by IPO underwriters and their advisors,
the choice is often made to incorporate in Delaware. If that is done for a New Jersey based business, counsel should
remember to qualify the new entity to do business as a foreign corporation in this state.

There are a number of provisions that can be included in a certificate of incorporation that will achieve certain desired
results for a new corporation relating to management, restrictions on capital stock and similar matters. Two items in
particular deserve attention for start-ups that contemplate venture capital or other third party financing.

The first is a provision to limit the personal liability of a corporation's directors and officers for monetary damages for
breach of any duty owed to the corporation or its shareholders, except for breaches of the duty of loyalty, not in good
faith or involving a knowing violation of law, or resulting in an improper personal benefit. See N.J. Stat.Ann.§14A:2-
7(3)(West). Delaware has a similar provision. Del. Code Tit. 8, §102(7).

The other provision is to authorize so-called "blank check" preferred stock. Generally, the authorization of a new class of
capital stock requires an amendment to the certificate of incorporation. Because venture capital investments are often

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made in several stages of preferred stock, each having separate terms, it can be difficult to obtain shareholder approval
each time. Thus, corporate statutes allow the certificate of incorporation to authorize a number of shares of preferred
stock, to be issued in one or more series and having the rights, preferences and privileges designated by the Board of
Directors for each particular series. Thus, only Board approval is needed to authorize and issue a new class or series of
preferred stock, provided there is a sufficient pool of blank check preferred stock. See N.J. Stat.Ann. §14A:7-2 (West) and
Del. Code Tit.8, §102(a)(4).

Protection of Intellectual Property

This is a topic of crucial importance to technology companies, the principal assets of which are often their technology and
their key personnel. Counsel must first become aware of the distinctions among the various types if intellectual property
protection: copyright, patent, trademark and servicemark registrations. The distinctions, as well as the steps to handle
these matters, are beyond the scope of this article, but it is important that the company receive competent legal advice
from an experienced professional on these matters.

The nature of many high-tech company's business by definition involves the licensing of technology, whether as a
licensor, licensee or both. When the company acts as a licensor, among the many other issues it must address are
protecting its technology and its dissemination and use. Care should be taken in licensing agreements to require the
licensee to limit the access to the technology or secrets to those who need such access to perform their functions. This is
especially true for non-patented material. Non-competition, non-disclosure and non-solicitation agreements with a
company's employees are discussed below under Employment Agreements and Compensation.

Creation of Websites

This subject is not limited to high technology start-up companies. Many companies, as well as non-business
organizations, have developed websites and continue to update and improve them. We first discussed contracting with
website developers and pointed out that general contract law and the principles of contract negotiation apply here as they
would, for example, to a contract to construct a building, manufacture a machine or write a software billing program.
Thus, the contract must deal with the identity of the parties, the scope of the work to be performed, the time frame in
which to perform, customer acceptance or approval of the website, customer input into its development, the rate of
compensation and the schedule of payments and the remedies for defaults or breaches.

One issue that should be addressed separately in website development agreements is the issue of ownership of the
finished product and its components. Under the work for hire doctrine in copyright law, the ownership and right to
copyright the webpage belongs to the customer, or party that retained the developer, absent anything to the contrary in
the agreement. A developer may agree to this in general, but needs to be careful not to give the page-owner exclusive
rights to ideas that the developer used in the past or may wish to use in the future. There are a number of gray areas here
and the drafter of a website development agreement, representing either side, needs to be sensitive to them.

Another issue of concern is domain name ownership. A domain name is one's internet address. In 1999, the Lanham Act,
the federal trademark statute, was amended by the Anticybersquatting Consumer Protection Act. This Act lowers the
threshold for establishing infringement of a trademark or servicemark in the use of a domain name. The Act creates
liability on the part of a domain name holder who has a bad faith intent to profit from a registered trademark or
servicemark and registers, traffics in or uses a domain name that is either (i) identical or confusingly similar to a
distinctive mark or (ii) identical, confusingly similar to or dilutive of a famous mark. The owner of the registered mark
must only prove similarities between the registered mark and the domain name, not the consumer confusion that a
trademark owner must demonstrate under traditional trademark infringement analysis.

Owners of web pages should be concerned about liability arising from the operation of a website, particularly those that
create links to other sites. Thus, it is wise to include disclaimers on the webpage to attempt to limit liability for places to
which the web page might send a user. Similarly, if the page owner is selling products via the webpage, whatever terms
and conditions of sale it would put on a standard sales order (e.g., limitation of a warranty of merchantability), should be
posted on the website. Similarly, the page owner should at least attempt to establish jurisdiction for any disputes arising
from a web-based transaction (i.e., "Any disputes relating to the sale of products through this website will be governed by
the laws of the State of New Jersey and be resolved solely by the state and federal courts sitting in New Jersey.") The
enforceability of such provisions is questionable in many jurisdictions given the global reach of the internet.

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Counseling Start-Up High Technology Companies by W. Raymond Felton
Employment Agreements and Compensation

A well drawn employment agreement can protect the rights of both the employer and the employee, or at least create a
clear set of rules that govern the employment relationship. A primary issue is the terms of employment and the
employer's ability to terminate the relationship, either with cause or without cause. The definition of cause is frequently a
topic of significant debate. Of course, salaries, bonuses, and perquisites should be spelled out in the agreement.

Other than perhaps establishing an employment-at-will relationship in writing, the key benefit to an employer from an
employment agreement is the type of restrictions that can be imposed on the employee as a condition of employment.
These include (i) covenants not to compete both during and for a period of time after employment, (ii) non-disclosure of
trade secret and other confidential information agreements, and (iii) non-solicitation of key employees and customers
agreements.

An employment agreement should also require the employee to acknowledge that anything he or she invents or creates
during employment, and for some period thereafter, is the property of the employer. The agreement should explicitly
assign all right, title and interest in such inventions to the employer, and obligate the employee to assist in prosecuting
any patent applications that the employer chooses to make with respect to those inventions. The obligation to assist
should survive the term of employment, albeit for per diem compensation.

The foregoing topics apply as well to agreements with independent contractors. Companies that choose to retain
individuals on this basis rather than as employees should be aware of the payroll tax withholding and other issues this
raises.

Stock options are a key element of compensation in many cash-strapped start-up companies. An option is the right to
purchase a number of shares of the employer's stock at a certain price over a certain period of time. Generally, these
rights vest in stages over a period of years after the options are granted, with vesting contingent on the employee's
continued employment. There are a number of securities and tax issues that need to be considered with respect to stock
options but are beyond the scope of this article.

Venture Capital Financing

As with each of the prior topics, this subject could merit an entire book, and in fact many have been written about this.
Typically, venture capital investments are made in the form of preferred stock that is convertible to common stock, at the
holder's option, at some fixed rate or based on some type of formula. As noted above, companies attempting to raise
venture capital should have a charter provision authorizing blank check preferred stock so that the Board of Directors can
establish the terms of several series of preferred stock to be issued from time to time. (In reality, the investor generally
establishes the term and the Board approves them if it wants to obtain the investment.) The terms address issues such as
voting rights, dividends, conversion rights and terms, liquidiation preferences, Board representation, put and call rights
and anti-dilution protection.

The company needs to focus on the securities laws in these transactions, and counsel needs to be aware of the available
exemptions from securities law registration, both under federal and state law. The principal exemptions relied upon
under the Securities Act of 1933, as amended, are found in Regulation D, Rules 501-508, and under the New Jersey
Uniform Securities Act are found in N.J. Stat. Ann. §§ 49:3-50(b)(9) and (12)(West).

Our seminar concluded with Alan Goldman's presentation as to what investors look for, and among other things he
stressed a well conceived business plan and a high quality management team.

In summary, the seminar highlighted the wide range of issues and legal disciplines that are impacted by the
representation of start-up businesses, particularly in the high technology area. While it is probably not realistic for any
one attorney to have expertise in each of these areas, he or she should at least be aware of the issues in order to properly
advise clients and direct them to the appropriate specialists.

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Counseling Start-Up High Technology Companies by W. Raymond Felton