Formation

TLDR: It is generally best to form a company sooner rather than later and there are many benefits to forming a company, including limiting your liability.

In general, it’s usually time to consider forming a company when you have a great business idea and are committed to seeing it through. For the vast majority of Silicon Valley venture capital-backed start-ups, this means incorporating as a Delaware corporation (see FAQ: “Why should I incorporate a Delaware corporation?”).

There are many reasons why entrepreneurs choose to form a company, including the following:

1. Limit Personal Liability: A company is typically considered to be a separate legal entity from its founders, with its own assets and liabilities. When your business is conducted through the company, agreements are made between third parties and the company only, and the activities of the company and its founders are clearly separated by following the appropriate corporate formalities, you as a founder are generally protected from personal liability for the obligations of the company. Thus, you should seriously consider forming a company before launching a product in the market, entering into any agreements with third parties, or taking other actions for which you would not want to be held personally liable.
2. Formalize Co-Founder Relationships: Forming a company and entering into contracts between the company and each co-founder (e.g., stock purchase agreements and employment agreements) help to formalize the relative ownership percentages and responsibilities of multiple co-founders in a start-up. These agreements are usually a must before you can seek funding from investors for your start-up.
3. Consolidate Ownership of Intellectual Property: When you have multiple people developing portions of your business’s product or technology, it is important to consolidate the ownership of the potentially disparate intellectual property rights of each contributor. This consolidation can be accomplished by forming a company and having each person who works on the product or technology assign their intellectual property rights to the company. Once such rights are assigned to the company, any intellectual property developed related to your business will stay with your company. This process helps to ensure that your business has all of the rights that it needs to produce and market its product or technology, and will avoid confusion about intellectual property ownership if and when certain contributors move on to new projects or companies. These conversations can be difficult and are therefore important to have them upfront so that everyone has clarity before moving forward with starting the business.
4. Incentivize Your Workers: Companies are able to offer benefits, including stock options and other equity incentives, to attract, compensate, and retain workers. This is especially important for start-up companies, as cash is typically not a large component of compensation in the early stages of a start-up.
5. Easier to Take Investment: Forming a company creates a separate legal entity that can accept investment. Investors are accustomed to investing in companies and owning equity in the entity. Most Silicon Valley investors will not provide funding until after you have formed the separate legal entity.

Founding a company is not easy. There will be out-of-pocket costs and ongoing legal and tax obligations to maintain your company. If you are not 100 percent committed to your idea and running your own business, it may be a good idea to postpone forming a company.

You should also keep in mind that if you have a great idea but are currently employed, you likely should wait until you leave your current job before forming your new company (see  FAQ: “I’m currently employed. Can I work on my start-up?”).

Finally, if applicable, consider your immigration status. If your current immigration status does not allow you to work for a start-up, you should resolve any issues with an immigration attorney before forming your company.

TLDR: It is best to leave your current role before starting a new company and there are a host of complicated issues you will need to pay attention to if you decide to stay at your current job while starting a new company.

Although it might be tempting to begin working on your new start-up idea while you are still employed at another company, it is always safer to leave your current role before starting a new company, and in either case, there are a number of issues that you need to consider very carefully, including:

1. Existing Agreements:

First, you should carefully review your current employment agreements to determine your obligations to your employer. Are there any conflicts between the work that you are planning and these obligations?

Note that, even if you are not an “employee” of a company, you should review the terms of consulting, advisor, or other agreements with any company to which you are currently providing services. These other agreements may have provisions that restrict your ability to work on your own start-up while you are engaged with that company, which are similar to those discussed below in the context of employment agreements. Sometimes these restrictions last for a period of time after your current engagement ends.

Some agreements that you might have with your current employer include the following:

• Offer letter
• Employment agreement
• Invention assignment agreement
• Confidentiality agreement
• Non-competition and/or non-solicitation agreement
• Agreements that were signed in connection with the sale of a prior company

When reviewing your existing agreements, focus on provisions relating to intellectual property. In particular, you want to be sure that your current employer will not have a claim to the intellectual property that you are developing, or will develop, in connection with your new business. Well-drafted employment agreements typically include invention assignment provisions, which say (in the broadest terms) that any intellectual property that you create while you are employed belongs to your employer. Carefully assess these provisions. In order to protect your start-up’s intellectual property, you should consider whether you need to put your start-up plans on hold until you are ready to quit your current job.

2. Legal Duties:

Next, consider any legal duties that you may owe to your employer or to another party. These may not be spelled out in written agreements and may be less obvious. For example, if you are a director or an officer of a company, you owe a duty of loyalty to the company under the law to put the company first above your own interests, regardless of whether these duties are explicitly stated in a written agreement. Even regular employees have duties of loyalty to their current employee—for instance, to not compete with the company while still employed. If there is a possibility of business overlap or another conflict between the company you work for and your new start-up, consider whether to delay the formation of your new start-up until you can take remedial actions, such as terminating the conflicting agreements or relinquishing your current positions.

3. Potential Exceptions for California Employees

If you are an employee in California, Section 2870 of the California Labor Code provides certain exceptions to your employer’s ability to claim ownership of your inventions. In short, any invention that you create entirely on your own time without using anything that belongs to your employer, and that does not relate in any way to your employment or the business of your employer, belongs to you. If there is a dispute, however, it could be very difficult to prove that all of the prongs of this test are true (see below for the rule itself). So to be safe, you should either avoid having to rely on this exemption or be very cautious and careful if you are currently employed and beginning to work on your start-up on the side.

The following is an excerpt from Section 2870 of the California Labor Code regarding inventions made by an employee of a company:

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.

Conclusion: What This Means for You

Generally speaking, from both an investment and intellectual property perspective, it is simplest if you have no conflicting employment or other obligations when pursuing your start-up. In fact, until you fully commit to building and growing your start-up, most serious investors won’t commit to funding it either. Because investors review hundreds if not thousands of business plans in a given year, you should be careful not to give them any reason to pass on yours—especially if it’s a reason related to intellectual property concerns. Even if you may come under the legal exception above, investors have a higher bar for evaluating these concerns, as the cost of litigating an intellectual property claim (even if you ultimately prevail) can threaten or wipe out the value of their investment.

Quitting your current job to pursue your new start-up full-time, however, is not without its own considerations. Before handing in your notice to your current employer, take some time to understand the legal and financial implications of resigning from your job.

For example, any stock options or restricted stock that you have been awarded at your current job may be subject to vesting terms and exercise deadlines. If you are planning to exercise your options after you quit, make sure you have enough money in the bank to pay for your shares before the applicable deadline expires. You should also consider the impact of losing the employee benefits you may have at your current job.

Finally, when you leave your current job, make sure to return all company property, including computers, company files, code, proprietary notes, and any other such property. This will all help ensure that you have a clean slate at your new start-up and avoid any intellectual property complications that might arise from you keeping and continuing to use this property.

It might. As a general matter, an employer may own—either by operation of law or by contract—all rights to any inventions or works of authorship created within or resulting from the scope of your employment, on company time, or with company resources and equipment.

There are various things a potential founder of a new start-up 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 an 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.

It is important to review the documents for the following provisions:

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 their 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:

“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:

"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 Result from any work performed by the employee for the employer. 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 a 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, post-employment non-competes are generally not enforceable in California except for limited exceptions, including in connection with the sale of a business. However, although such a post-employment provision is unenforceable, California courts will enforce reasonable limitations against conflicts of interest during employment, such as preventing an employee from accepting another job that interferes with the employee’s duties and time commitment to the company. California courts will also enforce post-employment confidentiality obligations, meaning that, even if a former employee can compete and solicit, the former employee may be prohibited by contract and statute from using confidential information and/or trade secrets of their former employer to compete and solicit.

Therefore, most startup companies located in California do not have post-employment non-compete provisions in their standard employee documents, but they retain permissible confidentiality and conflict of interest provisions.

Although a post-employment non-compete provisions are generally unenforceable in California, employees who signed post-employment non-competes outside of California may still be subject to them, pursuant to the applicable non-California law and jurisdiction, even if the employee moves to California to compete with their former employer. In other words, running to California will likely not protect a former employee against an enforceable post-employment non-compete provision the employee entered into outside of California pursuant to non-California law.

A typical post-employment non-compete clause  provides:

“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:

A. 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); 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 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 start-up company founder needs to review carefully the scope of the definition of “competing business,” the geographic boundary of the limitation, 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 also not enforceable. However, although such a post-employment provision is unenforceable, California courts will enforce reasonable limitations against conflicts of interest during employment, such as preventing an employee from accepting another job that interferes with the employee’s duties and time commitment to the company. California courts will also enforce post-employment confidentiality obligations, meaning that, even if a former employee can compete and solicit, the former employee may be prohibited by contract and statute from using confidential information and/or trade secrets of their former employer to compete and solicit.  

Although a post-employment non-solicit provisions are generally unenforceable in California, employees who signed post-employment non-solicit provisions outside of California may still be subject to them, pursuant to the applicable non-California law and jurisdiction, even if the employee moves to California to conduct the soliciting activity. In other words, running to California will likely not protect a former employee against an enforceable post-employment non-solicitation provision the employee entered into outside of California pursuant to non-California law.

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 after employment with the company ends, such as one year after termination of employment. The California courts have recently clarified that post-employment non-solicits, like post-employment non-competes, are unenforceable in California. However, although such a post-employment provision is unenforceable, California courts will enforce reasonable limitations against conflicts of interest during employment, such as preventing an employee from accepting another job that interferes with the employee’s duties and time commitment to the company. California courts will also enforce post-employment confidentiality obligations, meaning that, even if a former employee can compete and solicit, the former employee may be prohibited by contract and statute from using confidential information and/or trade secrets of their former employer to compete and solicit.

Although a post-employment non-solicit provisions are generally unenforceable in California, employees who signed post-employment non-solicit provisions outside of California may still be subject to them, pursuant to the applicable non-California law and jurisdiction, even if the employee moves to California to conduct the soliciting activity. In other words, running to California will likely not protect a former employee against an enforceable post-employment non-solicitation provision the employee entered into outside of California pursuant to non-California law.

Thus, start-up 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. 

Although California courts will likely not enforce post-employment non-compete or non-solicit provisions, California courts will likely enforce post-employment confidentiality obligations, meaning that, even if a former employee can compete and solicit, the former employee may be prohibited by contract and statute from using confidential information and/or trade secrets of their former employer to compete and solicit.

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 start-up 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 start-up 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. 

Many of the 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 is probably not the right person to deal with a situation where there may be an IP dispute. 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.

TLDR: Keep in mind the various protections the popular company may have on its IP and also review any agreements with the company.

When considering whether an idea for a start-up can be a spinoff of a popular company, legally, you should keep in mind that particular company’s rights to its intellectual property and any existing contracts between you, the company, and/or its affiliates.

With respect to the company’s IP, you can broadly think about patent (e.g., utility and design), copyright (e.g., original works of authorship, including code), trademark (e.g., logos or slogans), and trade secret (e.g., customer lists) as the main sources of IP. While this doesn’t capture everything in the IP world (for example, there could be possible non-public company information), it’s a good place to start thinking about areas you should avoid in terms of your product, marketing, or other business activities.

In addition to company IP, you should consider existing contracts with the company and its affiliates. If you don’t work for the company, you should check whether you have agreed to any terms of service with the company or consider whether you may enter into future agreements with that company, its suppliers, and its customers, among other affiliates. It is possible to be liable for a “tortious interference with a third party contract,” so you should be sensitive to any existing company agreements and relationships when launching your business.

If you are employed at the company, you should be extra careful to consult an attorney regarding any existing confidentiality, non-competition, or non-solicitation agreements, as well as any other circumstances (e.g., using company time or property to build your spinoff will likely give the company a claim to whatever you have built). This scenario can create the most significant hurdles in launching such a spinoff project.

TLDR: You must be authorized to work in the U.S. and be careful to comply with applicable visa rules.

To work at a start-up in the U.S., you must be authorized to work in the United States, either as a U.S. citizen, a permanent resident (a “green card” holder), or under a visa that authorizes employment. There are various visas that can apply to startup founders, such as the O-1, E-2, L-1 and others depending on the circumstances. Some visas, such as the B-1 or H1B visa, carry important restrictions, so be careful to always comply with the terms of your visa.

If you are not a U.S. citizen or permanent resident but wish to work at a start-up in the U.S., you should consult with an immigration attorney to explore your options. There are many immigration attorneys who focus specifically on these issues.

Note that even if you are not authorized to work in the U.S., you are able to own equity in a U.S. corporation and serve on the board of directors of a corporation.

TLDR: Always have an agreement in place with service providers or consultants.

Consultants should enter into a written consulting agreement prior to starting work for a company. The agreement should include invention assignment provisions. Sometimes, a consultant’s ability to assign rights to their work product may be affected by other agreements that they are bound to, so it is important to ensure that the consultant is legally able to assign any work product they create and to which your company needs the rights, and that the consultant signs the written consulting agreement before any work begins.

When engaging independent contractors, employers must be careful to properly classify independent contractors as independent contractors, or else the employer risks misclassification-related risks.

The right time to consider IP protection is at the company’s inception. It’s important to think about IP protection early in the start-up lifecycle, as many start-ups have considerable IP developed prior to formation that is usually assigned to the company in exchange for founder’s stock.