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Legal Basics For Software CEOs: Jack Russo, Russo & Hale LLP
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Angel Mehta: For an entrepreneur, legal fees based on billable hours can be costly. Does the fee structure used by a firm get reflected in its culture? Is a more expensive firm generally more effective?
Jack Russo: No. But there are definite cultural differences between firms that have large teams with large educational collateral functions for their junior people and have no problem issuing large bills, versus those that have a culture designed towards efficiency, effectiveness, and continued success on meeting budgets.
I remember a story that I was told while I was on the Board of Directors of a company…I hold an MBA from Columbia as well as a law degree from UCLA…the CEO came into a Board Meeting and he said, “you know, at an XYZ law firm that we’ve used, the document goes from the tax department to the securities department to the corporate department, back to the tax department, back to…” It was amazing – just this endless loop of reviews – probably because changes made by the securities department give rise to issues in the tax department which in turn gives rise to issues in the corporate group. No one owned responsibility for delivery, and the billable hours are just churning out on this document.
The CEO finally figured out that the problem was the internal process within the firm. They had a “No-One-Owns-This” culture, so, of course, we’ll just pass the buck until we figure out whether every answer and every possible mistake has been identified. Obviously, it was not effective. I mean the bills were ludicrously high and the document wasn’t getting done for signature. That’s a classic example of what can happen as specialization becomes so narrow that documents just float around from one department to another and the client is just paying the price for what really becomes almost an academic exercise.
Angel Mehta: Out of curiosity, then, should software CEOs and entrepreneurs lean towards an attorney that has an MBA versus a lawyer that doesn’t? I do find that the problem with some lawyers is they have no business sense.
Jack Russo: I don’t think you need an attorney who has an MBA, but rather a senior partner who recognizes ownership. Once you have this, the document is going to get done as though that partner were the client. If that doesn’t happen, the attorney is going to be taking the client’s view that the firm is failing them.
The partner almost becomes the advocate for the client within the firm. That’s really why larger companies have inside General Counsels to function as that police officer, making sure the stuff is getting done.
Angel Mehta: Let’s talk about intellectual property -- obviously, a critical issue for our clients as they are all software companies. At what point does an entrepreneur need to start thinking about patents?
Jack Russo: That can be relevant even prior to angel financing. You’ll have some sophisticated angels that’ll say, you know, these guys really didn’t do the right thing in protecting their intellectual property. The gentleman I spoke about earlier has spent a lot of money on prototype development and very little on intellectual property protection. When we raised the issue, well, what happens if the market proves out and volume sales start to occur and IBM or Dell or HP decide to follow you…what do you have that actually protects you? The answer was… not much.
Unfortunately, the patent laws only give you one year from the date you first present the product to the market -- the first date you really suggest that the product is available for sale. There’s a time-clock ticking and, indeed, overseas you really have to file even before you present the idea to the market. So, there has to be a fair amount of work done before you even know that there’s going to be revenue or else you could lose valuable intellectual property rights.
Angel Mehta: So what is your advice, then, to an entrepreneur who has precious little capital and needs to decide how far to go with securing a patent or protecting IT?
Jack Russo: He has to bring in a law firm that will partner and take some risk with him. The other alternative is to budget for some hourly fees, or some project fees, with a law firm that will do some type of hybrid deal. Also we’ve seen some enterprising entrepreneurs, although we don’t necessarily recommend it. The entrepreneurs file their own provisional patent applications, which really are just descriptive documents designed to describe the invention, not necessarily designed to make any legal claims that really a lawyer should be doing. Sometimes, the provisional is good enough to hold a date that protects a client and sometimes they’re not. So at minimum, I think, they need to be thinking about how to get some protection, and that’s typically through a provisional patent application and confidentiality agreements. They want to ensure they are not under-protected.
Angel Mehta: Let’s talk about the legal aspects of venture capital. What are some common legal mistakes entrepreneurs make when accepting financing from venture investors, in terms of protecting themselves or the partners? What would you advise?
Jack Russo: They need to understand that if they are going to take money that they’re fundamentally going to lose control of the business. That’s probably the biggest issue. So it really comes down to not necessarily just percentage ownership of shares but Board composition changes.
So our advice generally is to take the least amount of money to generate the most amount of leverage. Give up the least amount of control. Give up the least amount of dilution. So let’s take a five-person Board, where the intention is to sell 20% of the company that’s to be valued pre-money at $1.6 million. The company’s going to take $400,000 and it’s going to get it to a $2 million valuation. So to think about that 20% as justifying with just one Board seat, the control should be in the hands of the team. This done, find a venture firm, or an angel firm which accepts that it is going to get a good early-stage valuation at $1.6 million. Then what will happen in a year or two is that the value grows dramatically. Eventually, the Board will not have as much control as before, because the typical venture capital investment will likely “shift” the Board -- two of those five seats being held by venture firm, and one outside designated director who’s kind of operationally potentially in control. Of course, the outside director will be aligned with the venture folks simply because they’re being appointed over and over by the venture firms.
Also they need to think about the relationship with that investor or that investment group. That it should be a co-operative relationship as opposed to a contentious relationship, and be honest about what the real risks are so that there are no hurt feelings when some of the negative stuff hits the fan. Because inevitably there will be challenges in a business.
Angel Mehta: What about entrepreneurs who start companies while working for an existing employer in California? What should they take into consideration before starting a business on the side?
Jack Russo: There are major planning issues because typically the employer in California will have very broad employee assignment invention agreements. So that’s the first document that has to be looked at carefully. You see, we live in a world where anyone, almost anywhere, can be connected to a corporate internet and get access to company information. Lots of ideas are related, or potentially related, to a company’s business. So when that happens, and the employee thinks this could be the next IPod invention and, gosh, I didn’t really think Apple was in the music business, Apple really wouldn’t ever claim somehow…and I’m just using this hypothetically…the inventor of the IPod saying I thought it should be separate from Apple. Apple would undoubtedly take the view that such device is plainly within the sphere of its employee assignment inventions agreement.
The second consideration, once we’re outside the scope of previous document, is making sure that the work is done on personal time, which typically be evenings, weekends, vacations, sabbaticals, time taken off, leave, that sort of thing. So the employer can’t say, wait a minute, you took unfair advantage of me. This isn’t the way this should have gone. I shouldn’t be in a position of feeling as though I’ve been taken.
Angel Mehta: Is there really such a thing as a ‘no moonlighting’ clause?
Jack Russo: Yes there is. California law will allow the employer to specifically restrain moonlighting. So what does it mean to be moonlighting? Does it mean you have to be a full-time employee, a part-time employee, a contractor? Because at some point there is a freedom within Labor Code 2870 that says wait a minute. If Jack wants to be able to write a philosophical novel on how to get ahead in life, you know, the law firm that he works for shouldn’t say somehow that that’s moonlighting.
The typical moonlight clause would be enforced in that obviously you can’t work for a direct competitor. You can’t work for a supplier where there are inherent conflicts of interest if that supplier is going to come back and negotiate harder based on price or information they get. You can’t work with some party who may end up releasing confidential information of the company in ways that would injure the company. You know, we can go down a list that gets more and more tenuous but, yes, California law will protect employers, at least requiring disclosure of what it is that the person is doing and some opportunity to review the risks and review whether, well gosh, if he’s going to do that we’re not sure we can put him on this high-risk project because it could generate a conflict of interest.
Jack Russo is a frequent speaker on computer law issues and has given presentations to the American Bar Association, the Practicing Law Institute and the Computer Law Association. Jack serves as an arbitrator and mediator for the U.S. District Court (N.D. California), the Santa Clara County Superior Court, and the American Arbitration Association, as well as a Judge Pro Temporare of the Santa Clara County Superior Court. Feedback on the interview can be sent to: firstname.lastname@example.org
Angel Mehta is Managing Director at Sterling-Hoffman, a retained executive search firm focused on VP Sales, VP Marketing, and CEO searches for enterprise software companies. He can be reached for feedback at: email@example.com