The creation of a new business can be a fraught process. For new entrepreneurs, time, money, expertise, and energy are all at a premium. Incorporating, identifying investors, locating office space, hiring staff, and getting a product off the ground are all time-consuming activities, and all require the execution of binding commercial agreements. As a result, there is substantial pressure to skip detailed review of these contracts. The temptation to “deal with it later” in order to begin operations ASAP is a serious pitfall for any new business owner or startup investor. Additionally, new entrepreneurs or first-time investors may not know what to look for when examining early-stage documents for clauses that will cause trouble down the line. Below, we have put together a short list of problematic “red flag” contract clauses that the unwitting founder may find in their early-stage documents.
Before reading any further, understanding that many businesses should include some restrictive covenants as a matter of course, particularly when negotiating employment arrangements. Nondisclosure agreements help to protect valuable intellectual property and trade secrets–our post here discusses NDAs in more detail. Non-solicitation agreements can help safeguard existing business clients from poaching if an employee moves on to a new field. For employees in particularly sensitive positions, broader non-competition clauses that bar the employee from working in the same industry for a reasonable period of time may be necessary. However, rushing through the drafting process or simply attempting the ‘kitchen sink’ approach with restrictive covenants can backfire badly if an employment relationship ends and enforcing such a provision becomes necessary.
Non-competition agreements can be problematic if they are not written carefully with specifically negotiated restrictions in mind. Generally speaking, non-competition agreements must be reasonably limited in time and geography, and cover a specific industry to be enforceable. Additionally, states vary wildly on the enforceability of such contract provisions. State policies range from California’s near-absolute refusal to enforce non-competes at all to Ohio’s laissez-faire approach that prohibits such agreements only if they are unreasonable.
Another commonly seen restrictive covenant is the exclusivity provision. Exclusivity provisions are typically written to prevent the parties to an agreement from doing similar business with competitors, but if not reviewed carefully can create major obstacles to a startup’s future growth.
Imagine this scenario: your new business engages a small marketing firm to promote your goods and services. You, concerned primarily with the firm’s quality of service and pricing, overlook that the firm has included a provision that bars your business from engaging “any other marketing firm or similar business” for the duration of the contract and a period after any future termination. Seems fair, right? Unfortunately, a vague provision like this can create serious headaches for an entrepreneur down the line. What if your business seeks to expand beyond the market the small firm operates in, enters negotiations to be acquired by a larger entity, or you simply seek to change your marketing services provider? That initial marketing agreement is now a potentially ruinous obstacle to any of these moves: on its face, it prevents the business from using any other service provider anywhere, and may also scare off a potential acquisition attempt if the acquiring party doesn’t want the headache of negotiating with the regional marketer.
Even worse, imagine this working in the other director – where a client tries to tie your company down so that you will not provide similar services to any competitor of your client. An early stage company might be tempted to get the business in the door, only to find that their hopes for expansion in a given market may be curtailed by an unfortunate clause in a professional services agreement.
When negotiating with another business or service provider, new entrepreneurs should be immediately cautious of any exclusivity provisions and ensure that the scope of any such restrictions is limited and well-defined.
Most Favored Nation Clauses
Another restrictive contract provision often responsible for future disputes is the “most-favored nation” (MFN) provision. Also known as a most-favored customer clause, in commercial contracts a MFN clause is typically a seller or service provider’s guarantee to a buyer that the buyer will receive prices that are at least as favorable as those provided to other buyers for the same products and services. Early-stage companies can be attracted or pressured into including MFN provisions as a means to close that first major sale, but do so at considerable risk to future operating freedom. MFNs are generally enforceable absent serious anti-competitive effects, and can prevent an expanding seller from attracting new business by offering price discounts to prospective buyers. Knowing that a seller or service provider is subject to a strict MFN may also scare off potential future customers who know they cannot negotiate with a seller beyond a certain price point.
New entrepreneurs should be wary of using MFNs as an incentive to generate early sales without serious consideration as to specific terms, and should view any buyer that insists on a strict MFN clause with skepticism.
Intellectual Property Clauses:
Assignment to the Company
Often, the most critical task for a new company is ensuring the protection of its intellectual property. Especially in the tech field, a new company’s proprietary IP may be its only real asset– meaning that its protection is of paramount importance. A properly drafted intellectual property assignment will ensure founding documents and employment agreements clearly and properly delineate intellectual property rights, properly maintain the company’s ownership and control of those rights, and make absolutely clear the company’s position on any intellectual property created during an employee’s term of employment. Employment agreements that are silent on important IP-related provisions (or worse, contain unconscionable provisions that a new business assumes will protect it) can be a new entrepreneur’s worst nightmare.
At an extremely general level, entrepreneurs should beware IP assignments that appear to give them rights to an employee’s independent invention, or copyrightable work created outside of the scope of the employee’s position. Overly aggressive protections, depending on the state, can be the same as having no protections at all. On the other hand, business owners should also be leery of beginning any employment relationship without solid intellectual property protections in place. IP assignments will generally be governed by the state contract law. Some states treat specific contract provisions in unique ways– for example, several states limit the coverage of ‘pre-invention’ patent contracts by statute. Similarly, states deal with unconscionable provisions in different ways, and knowing how a court will deal with them is a critical part of the drafting process.
Assignment or Licensing by the Company
For companies who are in the business of developing work product for a client, it is important to understand who owns the underlying IP at the end of the engagement. Is the work truly custom, and is the customer paying a fair price for absolute ownership? That may well be the case. But, an assignment may not be appropriate where the company deploys a similar solution for many different clients. In this case, the company should try to maintain ownership of the IP, while granting a restricted, non-exclusive license for the client to use the work product. This way, the company does not find themselves unable to make future use of their own work in the future.
Some of the most commonly misunderstood contract provisions in the start-up market are anti-dilution provisions. First-time investors may think that such clauses are designed to guarantee their ownership interest in a new venture against dilution in future financing rounds. Typically, well-written anti-dilution provisions are only designed to protect investors from the dilution in the financial value of the shares they purchased if shares are later sold at a lower price than the investors originally paid. New entrepreneurs should be extremely wary of any contract provision that purports to protect investors from any future reduction in their ownership interest through subsequent fundraising at a higher valuation; these clauses will also be major red flags for any potential subsequent investors.
Even well-written anti-dilution provisions will ultimately have the effect of diluting the founders’ equity if a company is forced to go through a down round and make up the difference in valuation to first-stage investors. New entrepreneurs that are seeking early-stage investors should consider these terms carefully, and absolutely ensure that all parties know what each term actually guarantees.