This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by David W. Dabbs, Robinson, Bradshaw Hinson, P.A.

You just spent the last five years of your life working virtually 24/7/365 to build your company into one of the most respected firms in its field. Three years ago you barely could raise enough money to fund payroll and rent. Now you barely have enough time to run your business because of all the meetings with investment banking firms that want to talk about taking your company public. You hear rumors about competitors going public, and your outside investors and board members tell you to strike while the iron is hot.

You wonder what it would be like to run a public company and how it will affect your lifestyle. Based on the valuation ranges under discussion, your net worth (on paper at least) makes you feel like you just won the lottery. Serious people are saying that you could be the “next Google,” and you wonder what that would be like. You imagine yourself ringing the bell on the New York Stock Exchange.

You decide to have dinner with an old college friend, who is the chief financial officer of a public company, to share your news (against the advice of counsel). What she says makes you think.

You ask her how much stock you should sell in your IPO, and she tells you that you will be told not to sell any stock. You wonder why, especially given that your private equity investor plans to sell part of its investment, and she tells you that public investors will view the sale of stock by you as a sign that you do not believe in the future of your own company. You ask her why the same rules don’t apply to your outside investor, and she laughs and tells you that they just don’t.

Your friend asks how your company is doing financially, and you tell her that you have turned the corner and are hitting your stride. Part of the reason for going public is to reduce the amount of company debt, which is significant. In terms of your company’s financial projections, virtually all of the investment bankers believe that it is reasonable to expect double-digit revenue growth every year for the immediate future.

Your friend needles you about these projections. How is a company that struggled to pay expenses less than one year ago suddenly worth hundreds of millions? What are the assumptions used to project such rapid revenue growth, considering the novelty of your industry and product. She asks what you would say to investors in your IPO if you did not meet these projections. You tell her that everyone understands the developing nature of your industry and the risks involved, and that only those investors who “get it” and are “in it for the long term” will invest. She shakes her head and laughs again, and this time it bothers you.

She asks you why your company is going public, and you tell her that everyone—your investors, investment bankers and outside directors—tell you that now is the time. You are getting pressure from your private equity investor, who invested over four years ago, to find a way to liquidate its investment. Although you have a good working relationship with them, you complain that they are “just about the money.” You want new investors and more flexibility to manage your business. You also need to find a way to reduce or refinance the significant debt that your company has accumulated. Going public, you think, will establish your company as the industry leader. Plus, you know how excited your employees will be.

As dinner ends, your CFO friend apologizes and says that she needs to get back to the office to work on her company’s next quarterly earnings announcement and SEC filing, which are due in two weeks. As she stands up to leave, she gives you a serious look and tells you that going public isn’t for everyone. You press her to be more specific, and she sits back down and tells you the following:

• First, don’t get caught up in the moment. For most companies, the buzz of going public tends to fade away quicker than one might think. After that point, you and your management team will be left to deal with the demands and scrutiny that come with being public. You will be required to think about disclosing every significant development in your business, both good and bad, shortly after it occurs, even if there are legitimate business reasons for keeping it quiet. You and your management team will spend an enormous amount of time dealing with being public—preparing press releases, public presentations, and public filings; responding to questions from the press and investors; and meeting with analysts and large investors who can be demanding, probing, self-centered and sometimes uninformed, and who can have a significant effect on the price of your company’s stock. Simply put, she says, no one wants to be public for the sake of being public.
• Don’t fall into the trap of going public without defining your goals and considering your alternatives. Is your goal to find liquidity for investors, pay down debt, or establish a liquid market for your stock? If liquidity for investors is your primary goal, are there other buyers out there? Will being public help you raise more capital? Will having a publicly-traded stock help you acquire other companies? Where is your company in relation to where it needs to be, and how exactly will being public help?
• Stop thinking about going public as an opportunity to get rich. Your investors may look at it this way, but for you and your management team, it will be the beginning of a new and extremely challenging era. Because public investors tends to frown upon the sale of a significant amount of stock by insiders, you may not be in a position to sell much stock until years after an IPO. If personal liquidity is your goal, going public may not be the answer.
• Finally, quit thinking about going public as a goal. The process itself can be educational and eventful. But after the dust has cleared, being public can do as much harm as good. If your company hits a bump in the road, being public can make it worse. A negative development affecting your company’s stock price could well result in litigation regardless of whether anyone did anything wrong. She asks you whether your company is ready for that.

As your friend stands up to leave, she tells you that going public is an option available to very few companies and a sign of tremendous success. She says her point is to be careful and to approach the decision seriously just as you have approached every other major decision involving your company. Although going public can be exciting, being public is a challenge. Knowing, accepting and planning for this reality can make all the difference.

This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Matthew S. Churchill, Robinson, Bradshaw Hinson, P.A.

The last few articles in the Bench to Market series discussed capital raises and licensing-out arrangements that facilitate an entrepreneur’s commercialization of a new product or process. To obtain capital or a licensing arrangement, an entrepreneur must often share a business plan and confidential information about the proposed product or process with potential investors or licensees. The entrepreneur should insist upon binding non-disclosure agreements that prohibit both the disclosure and misuse of such information, before disclosing any such valuable information.

While some inventors may hold intellectual property rights, such as patents, to protect their proprietary information, many entrepreneurs rely on trade secret protection early in the commercialization process. See our recent article, “Can You Keep a Secret?” Non-disclosure agreements are fundamental to trade secret protection, as they demonstrate that inventors have taken reasonable steps to hold their valuable proprietary information in confidence.

These agreements, however, are binding only on the parties who actually execute them. Certain venture capitalists and strategic investors may resist signing non-disclosure agreements as a policy matter or for fear that they may interfere with alternative projects or in-house development activities. Thus, entrepreneurs may need to develop “teasers” that provide basic background information on their product or process without disclosing sensitive proprietary information so that potential investors and licensees understand the benefits and burdens associated with executing a non-disclosure agreement.

To be effective, a non-disclosure agreement must identify the appropriate investor or licensee legal entities that are intended to be bound by the agreement. Those investor or licensee parties should also be responsible for breaches of the agreement by their affiliates and by any accountants, attorneys or other representatives to whom they provide information. Some non-disclosure agreements go one step further and require signers to obtain a separate non-disclosure agreement in favor of the entrepreneur from any affiliate or representative who is provided confidential information.

Non-disclosure agreements should carefully define the confidential or proprietary information subject to the agreement. If there are exceptions to the prohibitions on disclosure or use, they should be precisely and narrowly defined. Common exceptions include (1) information generally available to the public through no breach of the non-disclosure agreement, (2) information that was known by the recipient prior to disclosure by the entrepreneur, (3) information obtained by the recipient from a third party who is not bound by a confidentiality agreement or other obligation of confidentiality, and (4) information independently developed by the recipient. Exceptions (2) and (4) are subject to potential abuse by recipients; many confidentiality agreements eliminate exception (4) altogether and require that the recipient provide written evidence demonstrating the existence of prior knowledge to satisfy exception (2).

Although the main point of a non-disclosure agreement is to prohibit improper use and disclosure of the information, that prohibition is not in fact total. For example, the recipient considering an investment will “use” the proprietary information in assessing the potential investment, and so the agreement should not prohibit that use. Where an entrepreneur seeks assistance in commercializing a product or process, the use restrictions must be carefully balanced to permit necessary commercialization activities without allowing the entrepreneur’s know-how and proprietary information to become part of the public domain. Simply describing a permitted use as “commercialization” is overbroad and subject to abuse. The parties must think through the commercialization process carefully to define the circumstances under which proprietary information can be disclosed to others.

The entrepreneur also needs to think about what happens after the recipient has evaluated the confidential information provided. Agreements should permit the entrepreneur to require the return or destruction of proprietary information in a recipient’s possession at the entrepreneur’s request. But the return or destruction of documents may not be enough, since the recipient of the information still knows it. To cover that issue, the agreement should require recipients to maintain the confidentiality of such information for a lengthy or indefinite term.

What happens if the recipient violates the prohibitions in the agreement and, for example, discloses the information to another party? The usual legal remedy for breach of an agreement is to sue for money damages. But in a case such as this, it could be impossible to determine what the damages are—how can one value the potential value of proprietary information that could be a bonanza or could be a bust? The alternative is to provide an acknowledgment by the parties that breaches of the agreement cannot be cured by monetary damages alone, and that equitable remedies such as temporary restraining orders and injunctions are appropriate to restrain breaches. Then, if the recipient is breaching the agreement, the inventor can go into court and obtain a court order that will stop the recipient in his tracks. Some people may violate their agreements, but they will think long and hard before violating an order from a court.

Entrepreneurs should also consider whether to include a covenant that prohibits solicitation of employees, sometimes called a “no-poaching covenant.” Potential investors who gain access to start-up businesses may decide to pass on an investment but to offer employment to talented employees with whom they interact during due diligence. A tailored employee non-solicitation provision will protect the entrepreneur from employee raiding.

Confidentiality agreements are generally a precursor to more definitive investment or licensing agreements entered into after due diligence has been completed and a plan for commercialization has been developed. Entrepreneurs generally seek to include in these preliminary agreements language that disclaims any representations and warranties with respect to the proprietary information to be disclosed during due diligence. Such representations are warranties are more appropriate in the context of definitive agreements when the business arrangements and related representations and indemnities can be spelled out in detail.

While well-crafted non-disclosure agreements provide entrepreneurs with legal and equitable remedies for improper disclosure or use of proprietary information, the agreements alone may not be effective to stop “bad actors” from potentially harmful disclosures. Therefore, entrepreneurs need to undertake their own diligence about potential recipients of proprietary information to confirm that such persons are professional and respected participants in the marketplace.

This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Mark O. Henry, Robinson, Bradshaw & Hinson, P.A.

Last week in the Bench to Market series, we discussed the license-out business model as an alternative to raising capital for the commercialization process. Because the business idea is “your baby,” however, you are likely reluctant to let go of it so early in its journey. Instead, you may prefer the challenge of finding the money to bring your idea to market yourself.

We discussed earlier in this series the government funding that may be available for science and technology related research. Unfortunately, this source of funding does not pay for the expenses of commercialization. Thus, once you have maxed out your credit cards and fully drawn the home equity line your spouse warned you not to set up in the first place, you are likely to turn to the private sector to raise capital.

Naturally, the first place you will look for money is from the people you know best. As a school kid you learned it was easier to ask friends, family and neighbors to support your fundraisers than complete strangers. Looking for equity investors is no different. Pitching your business model to complete strangers such as angel investors or venture capital funds can be intimidating and frustrating; however, what may be less obvious is that asking your family and friends for an investment may implicate federal and state securities laws.

A common misperception is that securities laws apply only to the stock of large public corporations traded on an exchange. But Section 5 of the federal Securities Act of 1933 (the “1933 Act”) and most state securities laws prohibit the offer or sale of any securities without registration, unless there is a specific exemption from the registration requirement. For a private company that has not previously registered the sale of securities, registration refers to the process of filing with the U.S. Securities and Exchange Commission (the “SEC”) to go public. This is an onerous process that is not a viable option for an early stage company, and thus it is important to find an exemption.

The statutes define “security” very broadly. For example, a “certificate of interest or participation in any profit-sharing agreement” or an “investment contract” would each meet the test. One famous case considers whether interests in an orange grove constitute securities (though for you Eddie Murphy fans, orange juice futures are not regulated by the SEC as securities but rather by the CFTC as commodity derivatives). Generally any equity interest in a corporation, limited liability company, limited partnership or other business entity would be considered a security when the investor is relying predominantly on the managerial efforts of others to generate profits. Thus, if you and two of your fraternity brothers get together in a garage and form a company to sell personal computers and each of you intends to be an active part of the business, the equity interests you receive at formation are not “securities” under the federal and state securities laws. When you solicit money from your neighbor who is not an active part of the business, however, the equity being offered is a “security” and the sale of that equity (in fact, even the “offer” to sell that equity) is subject to the securities laws.

The good news is that just because an equity instrument is a “security” does not necessarily mean registration is required. The federal securities laws provide for several registration exemptions depending on the nature of the security or the nature of the transaction in which a security is sold. Equity securities in a company generally do not qualify for any of the security-specific exemptions. Instead, most issuers of equity securities must look to the transaction-specific exemptions. The most common exemption is Section 4(2) of the 1933 Act, which exempts transactions by an issuer not involving a “public offering.” Factors examined in determining whether a Section 4(2) exemption is available include (1) the number of offerees, (2) the pre-existing relationship of the offerees to each other and the issuer, (3) the number of units offered, (4) the size of the offering, (5) the manner of offering, (6) the information disclosure or access involved, (7) offeree sophistication, and (8) the absence of redistribution of the securities.

Unfortunately, this exemption does not always have clear, specific guidelines for determining whether it applies. The sale of equity on a one-off basis to your father, who is the chief executive officer of a major securities brokerage firm, is unlikely to be a “public offering.” On the other hand, buying an infomercial on late night cable television and hawking stock to anyone who calls your 800 number is a problem. In between those ends of the spectrum, things can be confusing. To bring some clarity to the issue, the SEC has over the years issued specific safe- harbor exemption rules. Among other things, these rules include limits on the aggregate amount of equity that may be issued and describe the types of investors who may be involved depending on their wealth and financial sophistication.

Prospective issuers of securities must also consider the laws, rules and regulations in each state where securities are offered or sold. Most states have laws that are similar to the federal scheme, though it is important to carefully review and consider the individual state laws as there may be important differences.

Another over-arching consideration when soliciting investments from your friends and family are the general anti-fraud laws. Both the federal securities laws and most state securities laws impose liability on any person who offers or sells any security where there is fraud, an untrue statement of material fact, or an omission to state a material fact necessary to make statements not misleading. This standard applies to all offerings of securities, both public and exempt private offerings.

If all of this is making your head spin, you are not alone. A careful securities analysis can be costly and time-consuming, and thus you may be tempted to skip this step during early stage fundraising efforts. This can be a costly mistake. Remedies for breaching federal and state securities laws include, among other things, (1) rescission of the purchase, (2) an injunction on the offering, (3) damages, and (4) government fines. In addition, improperly documented and conducted securities offerings can hamper future capital raises with funds or other institutional investors when the stakes are higher.

This commentary in the Genomics Law Report’s ongoing series

The drive to create something new and useful is an almost universal trait of entrepreneurs. This passion, however, is not always accompanied by the same enthusiasm for managing the more mundane tasks of taking an idea from a research lab or academia and making it available in the marketplace. In addition to the fundamental need to raise capital, the commercialization process requires a number of time-consuming and less glamorous steps, such as forming a company, hiring employees, establishing accounting systems, drafting contracts, securing appropriate facilities and, if all goes well, marketing and selling products and services. The process can often be frustrating, difficult and even infuriating at times, particularly for scientists or researchers. So, what can an entrepreneur, who wants to maintain her day job as a professor, physician or other professional but doesn’t want her valuable innovation to sit idle, do?

One option that has gained popularity is the “license out” business model. Under this approach, an inventor takes the initial steps of creating a new product or process, but then passes the torch to a third party to use the underlying developments to make the products and services available to the appropriate market. The inventor is relieved of the burdens of commercialization but continues to retain ownership of her work, putting her in a good position to profit from its market value (albeit with the lion’s share of any such profit generally going to the business partner who takes on the commercialization responsibilities).

While this approach sounds simple and straightforward, there can be traps for an unwary inventor. A threshold concern is that an inventor can license only those rights she has the right to license. That sounds obvious, but inventors are surprisingly prone to overlook this concern. If software is involved, the inventor should carefully consider whether her software incorporates licensed third-party software or open-source software. If a new product is involved, the inventor should consider whether her invention is merely an improvement to an underlying invention owned by a third party. Purporting to license rights that are actually owned by a third party is a sure recipe for disaster.

Assuming the inventor actually has the right to license something of value, the first key decision will be the selection of an appropriate business partner to commercialize the technology. Sometimes the inventor will be aware of the likely candidates because of familiarity with the applicable industry. If not, technology transfer offices, venture capitalists, industry experts and attorneys can be useful resources to identify and vet potential business partners. It should go without saying that the “one stop” shops advertised on television are often not the best choice for a business partner.

Once a business partner is selected, the primary task shifts to preparing and negotiating the license agreement. The license agreement will often be the only contractual tie between the inventor and the business partner, and it contains the critical terms governing the relationship. Licenses can vary significantly, depending on the exact relationship the parties choose to create, and so the inventor is likely to be poorly served by simply downloading and using any type of “industry standard” license. (The license agreement is sometimes accompanied by a services or R&D agreement pursuant to which the inventor agrees to provide ongoing services, but that arrangement is beyond the scope of this article).

The heart of almost every license arrangement is defining the scope of the license grant. In a typical license, the inventor grants the licensee the right to use all of the inventor’s intellectual property rights in the new product or process, so that the business partner will have the legal authorization to make, commercialize and sell products and services incorporating those licensed intellectual property rights. The typical license would cover patents, unpatented inventions, proprietary know-how, copyrights and related documentation.

Assuming the inventor is willing to grant such a license in all of her intellectual property rights, there are still several decisions that must be made to define the scope of the license grant. First, is it exclusive or non-exclusive? In an exclusive arrangement, the inventor restricts her ability to allow anyone else to use her technology, and grants all of her rights to the business partner. Whether to grant exclusivity is something that must be carefully weighed by the inventor, although she should expect that her business partner will usually require it as a condition to making the investment. The inventor should negotiate protective provisions to ensure that the technology is actively marketed and that she has termination rights in the event that her expectations are not satisfied. If the license is non-exclusive, the inventor may not have the same concerns because she retains the discretion to license the technology to other partners if she becomes dissatisfied with the performance of the initial business partner.

Another issue is whether the license grant extends to all “fields of use.” For some technologies, this will not be an issue, because the new products or processes can be used only in a certain industry and the related intellectual property rights would have no relevance outside that particular industry. It is not uncommon, however, for an invention to have potential application in two or more industries, and a single business partner may not be best situated to take advantage of the commercial opportunity in each area. Instead, an inventor may desire to grant exclusive licenses to different business partners, with each license covering a specifically defined field of use. The drafting of field-of-use definitions is often heavily negotiated and requires precision to avoid future disputes.

The type and amount of consideration to be paid to the inventor are of course other critical components in the license agreement. Although the inventor may not plan to be significantly involved in commercializing the underlying technology, she expects to be fairly compensated for her contribution to the venture. The most common economic structure for licenses is the payment to the inventor of a royalty calculated as a percentage of the sale revenues or profits generated from the licensed technology. Various metrics can be used as the basis for the royalty calculation, including unit sales, gross sales, net revenues, and net profits. The percentage to be paid to the inventor can differ depending on the industry and the value and novelty of the licensed technology, and may fluctuate based on volume of sales. Because the data underlying such royalty calculations are under the control of the business partner, the inventor generally receives some form of audit rights to facilitate monitoring and confirmation of the royalty calculations.

Some inventors may prefer to negotiate a fixed payment amount, often through some combination of fixed upfront and periodic cash payments. This approach may be particularly attractive if the inventor is concerned about the challenge of monitoring the performance of the business, or if the technology is not being incorporated directly into the end product or service being sold to customers. The fixed payment has the additional benefit of discouraging any business partner from “parking” or “mothballing” the technology, which conceivably could be in its best interest if it gains access to another comparable technology under more favorable economic terms, including a replacement that it develops on its own. From an economic perspective, the fixed payment structure is more similar to an outright sale of the technology than a typical license, since the payments do not vary based on the success of commercialization; however, it is more favorable to the inventor than a true sale, since she will retain ownership of the intellectual property rights and will be better protected if problems arise.

Another approach is to combine a traditional sales-based royalty with a minimum payment (generally calculated on an annual basis). Typically, the minimum royalty is not an unconditional payment obligation and the consequence of the business partner’s failing to meet the minimum royalty thresholds is termination of the license grant. If this type of arrangement is properly negotiated, it can combine many of the benefits of a traditional sales-based royalty and a fixed-fee payment. The arrangement can provide the inventor with the expectation of a minimum annual payment while she retains the right to participate in the upside of successful commercialization and the right to terminate the arrangement if commercialization is unsuccessful.

The fact that the inventor will retain ownership of the technology raises other issues. In many cases, the inventor will have obtained (or at least applied for) basic intellectual property protection for her new product or process before seeking a business partner. However, the parties will still have to allocate the responsibility and costs of pursuing intellectual property protection. Deciding the appropriate scope of protection and allocation of costs can be particularly difficult in seeking patent protection, since it is not always clear where patent applications should be filed or what specific patents claims should be pursued, and the cost of prosecuting patents can be significant. Finally, the parties must decide who will control enforcement actions against alleged infringers.

In negotiating the license, the inventor also must take into account the evolving nature of technology. The likelihood is that any licensed product or process will be improved and enhanced as it moves towards commercial availability. Depending on the relationship of the parties, those improvements may be made by either the inventor or the business partner. The parties will need to negotiate the ownership of any such derivative works, improvements and enhancements to the technology. In any event, the inventor should insist that royalties be calculated with reference to sales of all products or services that are based at least in part on the underlying technology, even if the commercially available products or services have been significantly enhanced by improvements or additions developed by the business partner.

Finally, the inventor will need to consider the downside—what if the project goes badly off course? For example, what if the resulting product sold by the business partner is defective and injures consumers or what if another company claims, after development is completed, that sale of the developed product would infringe its patents? Parties typically allocate these risks through negotiated indemnification provisions. As a starting point, the inventor will generally request that the business partner provide comprehensive indemnification against any claims that might be brought against the inventor arising from the business partner’s commercialization of the technology. The business partner may reasonably request that certain claims be carved out from its indemnification obligations, and may even require the inventor to provide indemnification in certain circumstances.

We have mentioned only the typical key issues in this post. License agreements can be lengthy and complicated and will contain a host of other provisions that are important and can affect the relationship between an inventor and the business partner. It would be a mistake to view the license structure as a quick and simple answer to commercialization. On balance, however, the license model provides an attractive alternative to an inventor who wants to remain at her current position or continue to act primarily as a generator of new ideas while passing along the responsibility of commercializing the fruits of her labor.

We discussed earlier in the Bench to Market series the selection and formation of the legal entity that will own the technology and carry on the business of the founders. In connection with this formation and prior to engaging with investors, contractors, and others, the founders of the new business should establish clearly the terms of the venture as between themselves. They need to consider carefully and come to agreement on the ownership, management, and other important aspects of the business. Ultimately, through their discussions and with the aid of an attorney, the founders should have a set of legal documents that completes the formation of the entity, reflects clearly and with precision the terms of the venture, and prepares them to operate the business in the market without disruption. Below is a summary of key terms of the venture arrangements that the founders of any new business should establish with each other.¹

Ownership

The founders need to make the threshold determination of who owns the legal entity and in what percentages. If the entity is a corporation, this determination will dictate the allocation of profits and control of the business. If the entity is a limited liability company, the founders will have the freedom to set up procedures for control that need not reflect the ownership percentages. Ownership percentages typically are derived from the value of the respective assets contributed by the founders to the business. This value is easily determined when the founders contribute cash; however, a founder may contribute intellectual property, services, or other intangible assets, and in those cases valuation becomes more difficult and potentially contentious. If a founder receives an ownership interest in exchange for services (i.e., “sweat equity”), it may be appropriate to condition the ownership on the satisfactory completion of those services.

Ownership interests issued to the founders usually will be of the same class or type, such as common stock if the entity is a corporation. The founders may, however, create different classes of interest to provide for various rights and preferences as between themselves. For example, one of the founders may receive a “preferred” interest, which entitles him or her to priority in the distribution of profits from the venture.

The founders also should consider whether to create an equity compensation plan, through which the company may grant ownership interests to employees, contractors, and even the founders themselves in order to establish incentives for the performance of services to the company. Important considerations include: (i) the percentage of the company’s ownership allocated to the plan; (ii) the types of equity granted under the plan, such as options, restricted stock or “phantom” shares; and (iii) the conditions to vesting of rights to the equity, such as length of service or achievement of performance milestones.

Management and Governance

The founders must also decide who will be responsible for and have authority over management of the business as well as the structure of the management arrangements. While governance structures vary depending on the type of legal entity, this normally requires the designation of the following in the case of a corporate entity: (i) a board of directors (or managers in the case of a limited liability company), which oversees the affairs of the business; and (ii) officers (e.g., a chief executive officer), who manage the day-to-day operations of the business. Often the founders themselves fill these roles at the onset of the venture, as the founders’ need for and ability to pay qualified outsiders persons may be limited. The respective rights and duties of directors and officers should be carefully defined, including the terms of their authority, meeting dates and protocols, and removal arrangements.

In most businesses, the owners themselves, acting in their capacity as shareholders or limited liability company members, will reserve to themselves certain important decisions and delegate to the directors or managers other decisions. In a corporate structure, for example, the officers typically have authority to take routine, everyday actions on behalf of the business while the board of directors must vote on more significant, non-routine decisions; the owners would reserve to themselves the most significant decisions, such as a potential sale of the business. It is thus important for the founders to determine exactly what vote is needed by the owners to take an important action. A simple majority of the applicable voting group is normally authorized to take most actions; however, it may be appropriate in many situations to require a greater vote or to give the minority owners a veto over certain actions.

Transfer Restrictions

When starting a venture, the founders, who know each other well, voluntarily choose to associate with each other. Thus, to prevent being compelled to carry on the venture with other persons, the founders should consider whether to restrict each other’s ability to transfer their ownership interests. For example, a founder may be prohibited from transferring his or her interest without the consent of the other founders subject to certain qualifications. Alternatively, the other founders may have a right of first refusal in connection with any proposed transfer, i.e., a right to purchase the interest on the same terms and conditions offered to the potential buyer or on other terms that are agreed upfront.

Exit Events

Of course, for many founders, the ultimate goal of the venture is an “exit event,” such as a sale of the business to an established company or an initial public offering. While an exit event may seem only a distant hope at the onset of the venture, the founders would be prudent to consider and determine at the start such important issues as who can decide when an exit event occurs and upon what terms and conditions. This foresight should enable the founders to minimize disputes as the business grows and to increase the likelihood that they will realize their long-term expectations.

Most exit events will require the approval of the directors and owners, and as set forth above, the founders should be clear as to what vote is required. Also, the founders should consider providing for drag-along rights, which facilitate a sale of the company by entitling the majority owner to require the minority owners to sell their interests on the same terms and conditions as the majority owner, and tag-along rights, which protect the minority owner by entitling the minority owner to sell his or her interest on the same terms and conditions as the majority owner.
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¹When there is only one founder, most of this discussion is not applicable, as all ownership and control of the venture will typically belong to that person. Many of the issues presented will apply, however, if and when a sole founder desires to bring another person into the venture.

You’ve spent months or even years researching and believe you are on the brink of a major breakthrough. Your quest to develop a marketable product or technology is at a crossroads and, like many entrepreneurs, you wonder where you can find the funds to make your dream a reality. Luckily, public funds are available from a variety of sources to help fund research and development and commercialization activities. Public grants are a valuable source of funding that can mean the difference between commercialization success and the death of an idea before it makes it off the bench.

There are currently 26 federal government agencies that offer grants in a variety of fields. In this post we will focus on the two major programs offered by the federal government for small businesses/entrepreneurs, particularly those entrepreneurs engaged in science and technology related research. These programs are the Small Business Innovation Research (“SBIR”) program and the Small Business Technology Transfer (“STTR”) program. Each of these programs is intended to stimulate technological innovation, strengthen the role of small businesses in meeting research and development (“R&D”) needs, and increase private sector commercialization of innovations derived from federal R&D.

The SBIR offers qualified small businesses the opportunity to propose ideas that meet specific research and R&D needs of the federal government. Federal agencies with more than $100 million in extramural R&D are required to allocate a percentage of their budgets exclusively for small business grants. The current set-aside is 2.5%, which resulted in approximately $2.5 billion of available grant money in fiscal year 2009. The eleven agencies that participate in the SBIR program are the Department of Agriculture, Department of Commerce, Department of Defense, Department of Education, Department of Energy, Department of Health and Human Services, Department of Homeland Security, Department of Transportation, Environmental Protection Agency, NASA and the National Science Foundation.

The STTR provides the opportunity for small businesses to work collaboratively with non-profit research institutions on research or R&D projects. Federal agencies with more than $1 billion of extramural R&D must reserve a portion of their budget for R&D small businesses and their partners. In fiscal year 2009, this resulted in the availability of $150 million for small businesses. The five agencies that participate in the STTR are the Department of Defense, Department of Energy, Department of Health and Human Services, NASA and the National Science Foundation.

Eligibility for the SBIR and STTR is limited to for-profit small businesses that are American-owned, independently operated and have 500 or fewer employees. In addition, STTR research institution partners must be located in the United States and be a university/college, domestic research organization, university-affiliated hospital or a federally Funded Research and Development Center. SBIR and STTR grant submissions are evaluated using the following criteria: scientific and technical quality and innovativeness of the idea; the significance of the scientific or technical challenge; the ability of the small business to carry out the project (i.e. qualifications of the principal investigator and other key personnel, adequacy of facilities and equipment, and soundness of work plan); and the impact of the project, judged by technical and/or economic benefits, the likelihood that the work would lead to a marketable product, or the likelihood the project could attract further funding.

SBIR and STTR grants are awarded in three phases, two of which are federally funded. Phase I funds a feasibility study to evaluate the proposed project’s technical merit. A Phase I SBIR grant winner may receive a maximum of $100,000 for use during a six-month testing period, and an STIR award winner may receive a maximum of $100,000 for approximately one year of study. Phase II funds two-year projects intended to finance the principal R&D effort to expand on Phase I’s results. A Phase II SBIR award winner may receive a maximum of $750,000, and a Phase II STTR award winner may receive up to $500,000. Only Phase I award winners are eligible to compete for Phase II funds. The SBIR and STTR programs also include a Phase III provision, which is intended to assist the grantee with commercializing the results of Phase II and moving an innovation from the laboratory or test facility to the marketplace. Although federal agencies support the commercialization effort, Phase III requires the use of private sector or other non-SBIT/STTR funding. Thus, although Phase III does not provide any direct governmental funding, participation in Phase III gives added credibility to a project seeking private funding. Also, in certain circumstances, some agencies offer follow-up “Phase IIB” or other matching funds to assist with commercialization of an innovation.

In addition to the federal programs, many states offer programs that work in conjunction with the federal programs. For example, the North Carolina SBIR/STTR Phase I Incentives Program (pdf) provides funds that can be used to pay for a portion of the costs incurred in preparing and submitting Phase I proposals for the SBIR and STTR programs. These awards can be up to the lesser of 50% of the approved proposal preparation costs or $3,000. The North Carolina Board of Science and Technology (the “Board”) administers the North Carolina incentives program, and applicants may apply for the awards in response to solicitations developed and issued by the Board. Applicants must conduct at least 51% of the activities described in the SBIR/STTR proposal within the state of North Carolina and must maintain significant operations in North Carolina during Phase I of the SBIR/STTR program if a federal award is received.

North Carolina also offers matching funds to small businesses that have received an SBIR or STTR Phase I award. Awards under the North Carolina SBIR/STTR Phase I Matching Funds Program may equal up to 100% of an applicant’s SBIR/STTR award, capped at $100,000. Grant recipients receive 75% of the award upon receipt of an SBIR/STTR Phase I award and the remaining 25% if the Phase I report is accepted by the funding agency and the applicant submits the related Phase II application. The Board also administers the matching funds program and applications are submitted to the Board in response to solicitations issued by the Board.