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Know the Law Before Starting a Small Business

By C. Peter R. Gossels

When "Harry" heard that his employer was going to lay off senior engineers a few years ago, he decided that the time had come to start a business of his own to develop and market a new device he had designed, a device which might transform the data communications industry. But Harry did not have the time or resources for such a project by himself.

So, he called old friends to see if they might be interested in such a project. Some days later, Harry met with Brian Bosworth, the treasurer of a software company, and Sandra Sayles, a vice president of marketing for a manufacturer of electronic components. They were impressed with Harry's invention and its prospects.

After several meetings, Bosworth, Sayles and Harry agreed to pay $25,000.00 each for 25,000 shares of the common stock of their new company, Startup Corp., and a seat on its board of directors. Bosworth recommended that Startup be incorporated under Delaware law, which offered greater protection to corporate management than Massachusetts.

The directors elected Bosworth President of Startup because of his managerial experience and contacts in the financial world. They elected Sayles Vice President of Marketing and Clerk and Harry as Treasurer.

Harry quit his job as soon as Startup had been organized to devote his full time to develop his invention while Bosworth and Sayles continued to work for their former employers. While he worked harder than ever, Harry earned a lot less than he had at his former job, because the Founders had agreed to work for a subsistence wage until they had raised the financing required

The Founders rented space in Framingham, Bosworth and Sayles joined Startup and Harry succeeded in creating an extraordinary device that proved to be very attractive to the prospective customers that Sayles had been approaching.

Although the Founders raised some additional seed money and cut their salaries further, Startup exhausted its working capital within nine months. The Founders worked without salary for weeks as Harry perfected his invention. Sayles drummed up sales and Bosworth tried to persuade venture capital companies to provide the financing that Startup needed to survive.

One day, Bosworth reported that he had persuaded a group of VCs to invest $6 million in Startup. But, the VCs demanded preferred stock worth about sixty percent of the company and the two seats on Startup’s board that Sayles and Harry had held. The common stock held by the Founders would hereafter be restricted so that twenty percent of each Founder’s stock would vest within one year and an additional twenty percent would vest each year thereafter until all of the shares had vested. But if any Founder were to leave Startup for any reason with or without cause, Startup would have the right to buy back the unvested shares at the original purchase price. The Founders would also be expected to sign employment agreements, which contained non-competition provisions, but no right to be retained as an employee of Startup. After much discussion, the Founders agreed that Startup could not survive to exploit Harry’s invention without the new financing offered by the VCs, but they promised to protect each other and their respective interest in the company. So, the Founders signed the refinancing and employment agreements approved by their attorney, which provided that said agreements would be construed under Massachusetts law.

As time passed, Harry perfected his device and developed a number of other products that appealed to Startup’s customers. And as Startup’s products came to be accepted in the data communications industry, some publicly listed companies became interested in purchasing its products and acquiring Startup. Harry worked hard to interest representatives of those companies in Startup, because he hoped that the value of his stock, which had already risen in value as a result of his contributions and sacrifice, would rise even more if Startup were acquired.

Then one day, three years after the refinancing of Startup, Bosworth fired Harry without warning or cause, giving no reason for Harry’s sudden termination. Four days later Startup demanded that Harry sell his unvested stock to Startup for $10,000.

Harry’s attorney was sympathetic and advised him that Bosworth had breached the fiduciary duty of utmost good faith and loyalty that Bosworth and Sayles owed to Harry, a fellow founder and shareholder of a close corporation under Massachusetts law, by terminating him without cause in order to acquire his shares in Startup at less than fair value. Harry’s attorney explained that his opinion was based on a long line of Massachusetts cases starting with Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578 (1975) and culminating in one of the DeMoulas cases (424 Mass. 501, 511 [1997]) which had held that Massachusetts law applies to Delaware corporations where none of the parties had any relationship to Delaware beyond Startup’s incorporation there and all of the claims were based on events that occurred in Massachusetts. Based on the advice of his attorney, Harry refused to tender his unvested shares to Startup.

Two months after his termination, Harry read that Startup had been acquired by a Big Board company for cash and that his unvested stock should be worth a million dollars as a result of said acquisition. And when he learned that Bosworth had reached an agreement in principle for the acquisition of Startup the day before he had fired him, Harry sued Bosworth, Sayles and Startup to recover what his stock would have been worth if he had not been fired.

So when the defendants moved for summary judgement, the judge held that Harry’s case was not governed by the Donahue doctrine, but by Delaware law, even though all of the events that Harry had relied on had occurred in Massachusetts, except for the decision of the Founders to organize Startup under Delaware law. The judge also ignored the Founders’ stipulation that their refinancing agreement would be construed under Massachusetts law. Since Delaware does not impose a heightened fiduciary duty on shareholders (like Bosworth and Sayles) in a closely held corporation, Harry’s suit was dismissed.

As a result, Bosworth and Sayles reaped the benefits that Harry had worked so hard to obtain from his invention by simply firing him, while Harry was left to ponder the lessons he had learned from his first business ventu

Those lessons can be summarized quite simply:

  1. Don’t rely on the state of the law as it exists when you start your business; it is likely to change;
  2. Don’t rely on the oral promises of business associates, especially when the stakes are high; and
  3. Persuade your fellow founders to organize your start-up in Massachusetts, because you will be minority shareholder sooner or later.

Reprinted with permission from July 2, 2001 BANKER & TRADESMAN Law & Accounting

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