What do you need to do before you quit your job to form a startup company?

January 8, 2009

There are various things a potential founder of a new startup company needs to do before quitting their job.

1. Review all agreements with your current employer.  Most employees may have signed an offer letter and a confidential information and invention assignment agreement, as well as other documents such as a stock option agreement.  Depending on the company and the employee, other relevant documents might include a employment agreement, employee handbook, conflict of interest policy or severance/separation agreement. These documents should be reviewed carefully for provisions that may inhibit the future startup company.  Enforceability of some provisions in these documents, such as non-compete clauses, generally depends on the state where the employee is located.

Reviewing the documents for the following provisions is important.

  • Confidentiality.  All technology companies require employees to sign a confidentiality agreement that prevents the employee from using or disclosing employer confidential information except for the benefit of the employer.  These confidentiality provisions are typically for an indefinite period of time, as opposed to a finite period like five years.  In any event, most states prohibit the misappropriation of trade secrets as a matter of law, regardless of whether the employee signed a confidentiality agreement or not.  Thus, a potential startup company founder needs to ensure that he/she does not use former employer confidential information in connection with the new company.
  • Invention assignment.  In addition, all technology companies require employees to assign inventions created during employment to the employer.

A typical invention assignment clause provides:

I agree that I will promptly make full written disclosure to the Company, will hold in trust for the sole right and benefit of the Company, and agree to assign and hereby do irrevocably assign to the Company, or its designee, all my right, title, and interest in and to any and all inventions, original works of authorship, developments, concepts, improvements, designs, discoveries, ideas, trademarks, or trade secrets, whether or not patentable or registrable under patent, copyright, or similar laws, which I may solely or jointly conceive or develop or reduce to practice, or cause to be conceived or developed or reduced to practice, during the period of time I am in the employ of the Company (including during my off-duty hours), or with the use of Company’s equipment, supplies, facilities, or Company Confidential Information, except as provided in Section 3.F below (collectively referred to as “Inventions”).

In California, there is an exception to this requirement to assign inventions if the employee has made the invention on his/her own time not using company equipment and the invention does not relate to the business of the company or did not result from work for the company.  California Labor Code Section 2870 provides:

(a) Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either:

(1) Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or

(2) Result from any work performed by the employee for the employer.

(b) To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded from being required to be assigned under subdivision (a), the provision is against the public policy of this state and is unenforceable.

However, an employee may still need to notify the company of an non-assigned invention under the terms of the invention assignment provision.  Occasionally, I have seen invention assignment clauses that require the employee to assign inventions created for a certain period of time after termination of employment, from six months to a year.  These clauses may be enforceable depending on the state and the facts and circumstances of the situation.

  • Invention disclosure.  Even if an employer does not require post-termination invention assignment, some employers include provisions in standard documents that require the employee to disclose inventions created (or patents filed) for a certain period of time after termination of employment.  This is less common and may be enforceable if it is reasonably necessary to protect the company’s business interests.
  • Non-compete.  In many states, non-competes are enforceable if they are reasonable in scope and duration.  However, non-competes are generally not enforceable in California except for limited exceptions, including in connection with the sale of a business.  Therefore, most startup companies located in California do not have non-compete provisions in their standard employee documents.  A typical non-compete clause provides:

A. During the term of my employment with the Company and period of twenty-four (24) months immediately following the termination of my employment relationship with the Company for any reason or any other amount of time as determined by the Company in accordance with the terms of my Employment Agreement thereafter (the “Noncompete Period”), I will not, directly or indirectly, for myself or any third party other than on behalf of the Company, without the prior written consent of the Company:

(1) engage in the “Geographic Area” (as defined below) as an employee, agent, consultant, advisor, independent contractor, proprietor, partner, officer, director, or otherwise of a Competing Business (as defined below);
(2) have any ownership interest (except for passive ownership of one percent (1%) or less in any entity whose securities have been registered under the Securities Act of 1933 or Section 12 of the Securities Exchange Act of 1934 or the securities laws of any other jurisdiction of the United States) in a Competing Business; or
(3) participate in the financing, operation, management, or control of a Competing Business.

B. “Competing Business” shall mean any firm, partnership, corporation, entity, or business that [___________].

C. The “Geographic Area” shall mean anywhere in the world where Company conducts business.

A potential startup company founder needs to review carefully the scope of the definition of Competing Business and the time period of the non-compete.

  • Non-solicit of customers and vendors.  Some employment documents also include a prohibition on soliciting customers and vendors of the employer.  In states like California where non-competes are generally not enforceable, provisions on non-solicitation of customers and vendors are likely to be considered a restraint on trade and not enforceable.  A typical non-solicit clause provides:

I also agree that for a period of twelve (12) months immediately following the termination of my employment relationship with the Company for any reason, I will not directly or indirectly solicit, divert or accept business from, or otherwise take away or interfere with, any customer or vendor of the Company, including any person or entity who was a customer or whose business was being pursued by the Company on or prior to the date upon which my employment relationship with the Company terminated.

  • Non-solicit of employees.  Most technology companies require employees to refrain from soliciting employees for a specified term, such as one year after termination of employment.  Thus, startup companies where founders intend to hire their former co-workers need to carefully navigate the bounds of permissible action under these clauses.  Please also keep in mind that key employees of company may be subject to fiduciary duties to the company and may be subject to claims of breach of fiduciary duty, fraud and intentional interference with contract for soliciting co-workers even in the absence of written agreements.  A typical non-solicit of employees clause provides:

I agree that for a period of twelve (12) months immediately following the termination of my relationship with the Company for any reason, whether voluntary or involuntary, with or without cause, I shall not either directly or indirectly solicit any of the Company’s employees to leave their employment, or attempt to solicit employees of the Company, either for myself or for any other person or entity. I agree that nothing in this Section 8 shall affect my continuing obligations under this Agreement during and after this twelve (12) month period, including, without limitation, my obligations under Section 2A.

  • No moonlighting.  Some employment documents contain explicit provisions that prevent employees from working on business activities unrelated to their employer, even if it is after hours.  This may limit pre-resignation activities.  A typical clause might provide as follows:

I agree that during the term of my employment with the Company, I will not engage in or undertake any other employment, occupation, consulting relationship, or commitment that is directly related to the business in which the Company is now involved or becomes involved or has plans to become involved, nor will I engage in any other activities that conflict with my obligations to the Company.

Some companies may have provisions that limit outside activities, whether related or unrelated to the employer’s business.

  • No conflicting stock ownership or directorships.  Some company conflict of interest policies prevent an employee from investing or holding outside directorships in other companies.  This may limit pre-resignation incorporation of a new company.  A typical conflict of interest policy provides:

The following are potentially compromising situations that must be avoided:

Investing or holding outside directorship in suppliers, customers, or competing companies, including financial speculations, where such investment or directorship might influence in any manner a decision or course of action of the Company.

2.  Return confidential information.  Most employment-related agreements require employees to return all company property to the employer.  A typical clause provides:

Upon separation from employment with the Company or on demand by the Company during my employment, I will immediately deliver to the Company, and will not keep in my possession, recreate, or deliver to anyone else, any and all Company property, including, but not limited to, Company Confidential Information, Associated Third Party Confidential Information, as well as all devices and equipment belonging to the Company (including computers, handheld electronic devices, telephone equipment, and other electronic devices), Company credit cards, records, data, notes, notebooks, reports, files, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, photographs, charts, any other documents and property, and reproductions of any and all of the aforementioned items that were developed by me pursuant to my employment with the Company, obtained by me in connection with my employment with the Company, or otherwise belonging to the Company, its successors, or assigns, including, without limitation, those records maintained pursuant to Section 3.C. I also consent to an exit interview to confirm my compliance with this Section 5.

Employees should carefully search all electronic and paper files for any employer material, including temporary internet files, emails sent to personal addresses, email contacts, and other types of information.  The inadvertent retention of these materials can be used by the employer in future litigation.

3.  Limit pre-resignation activities.  Creating intellectual property related to the current employer’s business, or otherwise using the current employer’s time or resources can be problematic due to typical invention assignment clauses in employee documents.  Employees must avoid using equipment (including employer-provided laptops), time, know-how, or other resources of their employer in connection with their new startup company.  In addition, no customers should be solicited for the new company, and no co-workers should be invited to quit and join the new company before resignation.

However, some pre-resignation planning is permissible to some extent. In general, describing general concepts for a new company that fall short of intellectual property creation and meeting with potential investors is permissible subject to the potential contractual limitations described above.  Investor presentations should be carefully drafted to avoid any inference that IP has already been created. Incorporating a company before resigning is probably also permissible subject to the same potential contractual limitations, keeping in mind that certain facts may seem bad in later litigation.

Keep in mind that key employees, such as officers, directors and managers) may owe a duty of loyalty to the company, regardless of whether there is a written agreement.  This duty would prohibit an employee from doing anything to harm the employer, such as competing with the employer or usurping and business opportunities of the employer.

4.  Prepare for the exit interview.  Many employee documents require employees to submit to an exit interview.  Prospective founders of a startup company should not lie in an exit interview if they are asked about their plans.  While there is no particular obligation to tell the truth, even a slight misrepresentation may be used against the founder in future litigation to show dishonesty.  Departing employees should prepare a high level, but truthful response to any direct inquiries by an employer regarding future plans. If the potential founder is going to form a competing company, the former employer will learn about it anyway if it is successful.

Departing employees must also be prepared to make written representations to their prior employers that they have returned all company information and material, and will continue to comply with confidentiality obligations.  A typical representation is as follows:

This is to certify that I do not have in my possession, nor have I failed to return, any devices, records, data, notes, reports, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, equipment, any other documents or property, or reproductions of any and all aforementioned items belonging to the Company.

5.  Stay on good terms.  Sometimes litigation arises simply because the former boss of a departing employee has a vendetta against the employee.  Keeping on good terms with your former employer may also be helpful if the employer might be a potential investor, customer or supplier for the new startup company.

6.  Don’t forget about stock options and benefits.  Most stock options expire within 90 days of the last day of employment. In some cases, the time period is shorter than 90 days.  If you want to exercise a stock option from your current company, you need to make sure that you do it within that time period.  Of course, exercising a stock option will require the employee to pay the exercise price for the options, and in some cases, the aggregate exercise price may be significant.  In addition, employees should make sure they understand COBRA insurance and how to transfer their 401(k) plans, along with other benefits issues.

7.  Consult with an attorney.  (I will write a post on “How do I find and hire a lawyer” in the near future.)  Many of issues described above are fairly tricky and the advice of a competent attorney is recommended.  In addition, if there are any potential issues regarding intellectual property ownership with former employers, consulting with an attorney is extremely important.  In fact, a general corporate attorney (like me) is probably not the right person to deal with a situation where there may be an IP dispute.  I typically get one of my IP litigation colleagues involved if there is any likelihood of a problem.  IP issues will come up in due diligence in a future venture financing or a sale of company, so it is extremely important to make sure things are done correctly from the very beginning.

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