the entrepreneur's guide to business law, 4th...

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The Entrepreneur’s Guide toBusiness Law, Fourth Edition

Constance E. Bagley,Craig E. Dauchy

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C H A P T E R

1Taking the Plunge

I ndividuals start businesses for any number and combination ofreasons: to be their own boss, to pursue a passion, to achieve

financial rewards, to establish a new livelihood after corporatedownsizing, to fill an unmet need with an innovative product orservice, or to create something enduring. Despite the vast varietyof entrepreneurs and their companies, once individuals decide tobecome entrepreneurs, they will encounter many of the sameissues. These issues will include whether to work alone or withone or more partners, which products or services to provide, andwhere to obtain the necessary capital.

One example of a highly successful entrepreneur is Mohamed“Mo” Ibrahim, the founder and chairman of Celtel, the leadingmobile telecommunications company in Africa. Born in 1946,Ibrahim studied engineering at the University of Alexandria inEgypt before returning to his home country of Sudan.1 After work-ing for Sudan Telecom, Ibrahim spent several years at the Univer-sity of Birmingham in the United Kingdom—first as a Ph.D.student, then as a research fellow. British Telecom (BT) thenhired him to oversee its foray into mobile communications. Astechnical director, Ibrahim helped develop the world’s first cellu-lar network, which began operating in England in 1985.

After Europe opened the cellular communications industry tocompetition in 1989, companies were attracted by the growthopportunities but often lacked the knowledge to design and imple-ment their own networks. Recognizing the demand for his

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expertise and wanting to determine his own fate, Ibrahim left BTto found Mobile Systems International (MSI) in 1989. In additionto consulting, MSI developed novel software that simulated net-work installations and operating conditions. MSI took equity posi-tions in some of its clients, building an investment portfolio thatwas eventually placed in a Dutch holding company, MSI CellularInvestments. The company was subsequently renamed CeltelInternational.

Celtel began building its multination network in Africa in1998.2 Although this business faced numerous unique obstacles,including lack of infrastructure in some areas and rampant cor-ruption, Ibrahim was convinced that cellular communicationswould help African countries expand their economies and buildtheir infrastructures by leapfrogging the installation of landlines.He also wanted his company to be an example of a business thatcould succeed without stooping to paying kickbacks and bribes.3

By 2005, when MTC, a Kuwaiti mobile telecommunicationsconcern, purchased 85% of Celtel for $3.4 billion, Celtel was oper-ating in 13 sub-Saharan countries and had more than 5 millioncustomers.4 Ibrahim remained as chairman of Celtel and throughhis Mo Ibrahim Foundation increased his commitment to battlingcorruption in his home continent. The Foundation funds the MoIbrahim Award for Achievement in African Leadership, a $5 millionprize awarded to the outgoing president of a sub-Saharan nationwho has demonstrated the greatest commitment to democracyand good governance.5 It also funds several scholarships, includingone to the London Business School for students from sub-SaharanAfrican countries.6

Before taking the plunge, the would-be entrepreneur should con-sider the sacrifices, both professional and personal, that will berequired. These sacrifices may include accepting several years oflow pay and long hours in exchange for a large potential payofflater. Successful entrepreneurship also requires a willingness totake risks. As Sandra Kurtzig, founder of Ask Computer Systems(a company she grew to more than $400 million in sales), pointsout, the act of quitting one’s job and starting a new business is onlythe beginning.7 An entrepreneur must continually take risks and beprepared to make the bet-the-company decisions that will determinethe venture’s ultimate success or failure.8

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Regardless of how carefully one deliberates before makingdecisions, an entrepreneur will make mistakes. As Kurtzig putsit, “Screwing up is part of the process.”9 One key to being success-ful is to make fewer mistakes than the competition.

Most entrepreneurs and their backers are not risk seekers;rather, they are risk takers who attempt to manage the risks inher-ent in pursuing new opportunities by making staged commitmentsand conducting a series of experiments.10 In selecting an opportu-nity to pursue, savvy entrepreneurs look for an attractive risk/reward ratio, that is, the set of possible negative and positivecash flows and the likelihood of each possible outcome.11

When harnessed correctly, the law and the legal system can bea positive force that helps entrepreneurs increase predictability,maximize realizable value, marshal the human and capitalresources needed to pursue opportunities, and manage risk.12

Failure to comply with the law can result in crippling lawsuits,devastating fines, and, in egregious cases, imprisonment for theindividuals involved. Because legal risks are among the mostimportant of the many risks faced by a young company, an

From the TRENCHESAdam Lowry and Eric Ryan bonded at a young age by, among otherthings, brainstorming ways to improve or reinvent familiar products. Inthe late 1990s, this childhood fascination turned serious when Adamand Eric had the idea of reinventing household cleaning supplies asenvironment-friendly products featuring elegant packaging. In 2000,they quit their jobs, used their savings as seed capital, and createdMethod Products, Inc. Adam and Eric began mixing their first all-purpose cleaner in a bathtub, delivering orders around the San Fran-cisco Bay area with their own pickup truck. After surviving the dot-com recession and near insolvency, they quickly spent their savingsand maxed out their credit cards. Method soon took off. By 2009, ithad grown to more than $100 million in revenues and earned a spotas one of Inc. magazine’s fastest-growing private companies inAmerica.

Source: How Two Friends Built a $100 Million Company, INC., available at http://www2.inc.com/ss/how-two-friends-built-100-million-company (last visited Feb. 27, 2010).

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entrepreneur can increase the likelihood of success by under-standing and managing legal risk, that is, by spotting legal issuesbefore they become legal problems. Legally astute entrepreneurscan also use legal tools, such as contracts and intellectual propertyprotection, to increase realizable value.



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PUTTING IT INTO PRACTICE

Pierre Harvey (our fictitious entrepreneur) had been an employee of SunSpot Cells, Inc. (SSC), a Delaware corporation headquartered in Texas,for six years before taking the plunge to start his own venture. SSC manu-factures crystalline silicon solar cells for use in two types of photovoltaicsystems for converting sunlight directly into electricity: (1) basic flatpanel modules, which expose semiconductor materials directly to thesun, and (2) concentrator modules, which use mirrors to direct sunlightonto the solar cell material. Silicon is the primary raw material used tomake these solar cells. Although silicon is widely available, using it forsolar cells is expensive because it must be refined to almost 100% purity.Even though concentrator modules use less silicon than flat panel mod-ules, increased demand and projected shortages of silicon had furtherdriven up costs over time.

Founded in 2001, SSC was the world’s third largest producer of pho-tovoltaic cells. It had revenues of more than $820 million in 2010. Eventhough SSC increased production each year, the ongoing shortage ofusable silicon made it impossible for SSC to satisfy customer demand.

Pierre began his career at SSC as an engineer in the quality controldepartment and advanced rapidly. At the suggestion of the head of engi-neering, Pierre used the company’s tuition reimbursement program toattend the Yale School of Management from 2006 through 2008. Afterhe earned his MBA, Pierre returned to SSC to oversee the developmentof next-generation concentrator cells. He spent the majority of his timedesigning and testing new mirror arrangements in an attempt to findone that would allow the cells to produce the same electrical outputwith less silicon. He also worked to develop less fragile concentratorcells. Decreasing the breakage rate would enable customers to installarrays of concentrator cells in a wider variety of locations, includingindustrial building rooftops.

Pierre had graduated from Stanford University in 2002 with an envi-ronmental engineering degree. While attending his fifth reunion in 2007,he bumped into an engineering classmate Maya Yoshida, who had just fin-ished the first year of the MBA program at Stanford’s Graduate School ofBusiness. Between college and business school, Maya had worked forKyosharpa, a large Japanese firm outside Tokyo that was the world’s fore-most producer of silicon solar cells. Following a presentation at thereunion on the need for increasing alternative energy sources in the UnitedStates, the two discussed developments in photovoltaics that might makesolar power more viable for use in everyday life.


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Both realized that reducing the cost of producing photovoltaic cellswas key. Most traditional photovoltaic cells produce electricity at a rate ofabout $3.50 per watt and capture just 10–20% of the sunlight energy strik-ing the cell. Pierre andMaya thought that thin film technology was a prom-ising alternative to traditional flat panel and concentrator cells for threereasons. First, thin film solar cells use less semiconductor materials thanflat panel and concentrator cells. Thin film cells are created by pouringextremely fine layers of semiconductor materials upon one another untilthey have a combined thickness of 1 to 10 micrometers. In contrast, tradi-tional cells, which aremade by slicing wafers from a pure silicon ingot, usea layer of silicon that is 100 to 300 micrometers thick. As a result, signifi-cant amounts of the expensive silicon are lost during production. Second,unlike traditional cells, thin film cells can incorporate alternative, lessexpensive semiconductor materials. Third, unlike purified silicon, whichis a solid typically produced in wafers with a fairly uniform shape andsize, thin film cells are initially in liquid form, so they can be molded intoany size or shape. This makes it easier to incorporate thin film cells intoexisting product designs.

Pierre and Maya also discussed alternative uses for photovoltaics. Inthe course of their work prior to business school, both had recognizedthat efficient solar cells would be attractive to many industries, includinghome building, automobile manufacturing, and electronics production.Demand for “clean technology,” or “cleantech,” had increased as con-cerns about global warming, volatile oil prices, and political uncertaintysurrounding the regulation of greenhouse gases prompted a search forviable alternatives to fossil fuels. If a clean power source could be inex-pensively incorporated into products without drastically altering produc-tion methods or the object’s appearance, and without diminishing itsperformance, they knew companies and consumers would be interested.The two also expressed a mutual desire to work for themselves one day.They promised to stay in touch and not wait until their 10th reunion tomeet again.

Following business school, both Pierre and Maya returned to theirprevious employers. But inspired by his conversation with Maya, Pierrespent much of his spare time over the next two years using computermodels to test designs for improving thin film technology. In particular,he was interested in replacing silicon with another semiconductor mate-rial, cadmium. Cadmium has an almost perfect bandgap, the minimumlevel of energy at which a material converts sunlight into electricity.Additionally, cadmium absorbs a relatively high level of incident sun-light. The more sunlight a semiconductor material absorbs, the more


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electricity it can produce. Pierre occasionally borrowed technical man-uals from work and attended SSC in-house presentations on relatedtopics.

Pierre frequently called Maya to discuss his findings, and she madeseveral helpful suggestions for tweaking the tests. They were careful notto discuss their outside project with coworkers. By early 2010, theyfelt they had a viable design for a cadmium-based thin film thatincreased the efficiency of previous cadmium-based designs by signifi-cantly reducing the amount of energy lost to internal resistance.

Pierre and Maya knew that if they were going to take the next stepwith their product, they would need to test their theoretical design withactual physical components. Faced with the prospect of investing moneyin addition to time, the two decided they should commit their businessrelationship to writing. They signed a brief handwritten agreement toform a company to develop what Pierre had taken to calling the CadWattSolar Cell (CSC). The agreement stated that they would “divide any prof-its fairly.”

Pierre took a two-month leave of absence to thoroughly test theirdesign in rented laboratory space. He and Maya split the rental costequally. Pierre discovered that his projections were accurate. The designwas efficient, absorbing nearly 20% of the sunlight energy striking thecell and retaining nearly 75% of the electrical energy that was lost inother cadmium-based designs. Additionally, he discovered that thesuperstrate of conductive material he laid over the cadmium was strongenough to hold the entire structure together, thereby eliminating theneed for a backing material. He and Maya envisioned affixing thesecells onto other objects, so they estimated that the cells would need lesssupport than the traditional cells used on rooftop panels. With theincreased efficiency and reduced raw material needs, Pierre calculatedthat the cell produced electricity at a rate of roughly $1.50 per watt—adramatic improvement over previous photovoltaic technology. Thisdiminished cost increased the chance that manufacturers and con-sumers would be interested in integrating photovoltaic cells into theirproducts and lives.

While Pierre was testing the cell design, Maya prepared a presenta-tion for potential investors and completed plans for commercializing thetechnology. She envisioned creating a company that would develop andsell thin film photovoltaic panels based on Pierre’s breakthrough tech-nology. She estimated that they would need $8 million to purchase thenecessary production equipment and materials and eventually to hireemployees. In addition, they would need to conduct further tests to


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ensure that the design was pliable enough to be incorporated into a vari-ety of products. She believed that the success of the design woulddepend on its ability to adapt to existing products rather than forcingmanufacturers to change their construction methods.

Pierre wanted to get their new venture under way as soon as possi-ble, and he realized that to do so he would have to leave SSC. For eco-nomic and family reasons, Pierre and Maya decided to set up their newbusiness in the San Francisco Bay area. Locating in California wouldenable them to take advantage of the California Solar Initiative, a gov-ernment program that provided $3.2 billion in incentives for solarpower installations over an 11-year period.

In preparation for his departure, Pierre asked to review his personnelfile to determine what agreements he had signed when he joined SSC.Pierre vaguely remembered being given a stack of papers to sign andreturn in conjunction with his post-business-school promotion to headof concentrator cell development. In his file he found forms for healthinsurance and tax withholdings along with a long nondisclosure agree-ment that he had only skimmed before signing. After reviewing theagreement more carefully, he realized that it contained provisionsassigning the rights to his inventions to SSC, a nondisclosure provision, aone-year covenant not to compete, and a no-raid provision prohibitinghim from actively hiring SSC’s employees. (For a further discussion ofthese provisions, see Chapter 2.)

Before taking any action, Pierre knew that they needed to investigatethese and a number of other crucial issues. Below are some of the questionsour founders will confront in the initial and later stages of forming theirbusiness and the corresponding chapters of this book that address hisquestions.

1. Who owns the CadWatt Solar Cell technology? What rights, if any,can SSC claim to it? (Chapter 2: Leaving Your Employer)

2. What can Pierre do to make his departure from SSC amicable?Should he have left sooner? What ongoing obligations does hehave to SSC? (Chapter 2: Leaving Your Employer)

3. Can Pierre ask several of his colleagues at SSC to join his newenterprise? (Chapter 2: Leaving Your Employer)

4. Should Pierre and Maya hire an attorney? How do they selectthe right one? (Chapter 3: Selecting and Working with anAttorney)

5. Given their limited budget, can Pierre and Maya afford anattorney? Can they afford not to have one? (Chapter 3: Selectingand Working with an Attorney)


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6. What would be an appropriate legal form for the business from aliability and tax standpoint? (Chapter 4: Deciding Whether toIncorporate)

7. How should Pierre and Maya approach the issue of splitting theequity in the new venture between them? (Chapter 5: Structuringthe Ownership)

8. How will they manage the venture? What happens if one of thefounders leaves? (Chapter 5: Structuring the Ownership)

9. What are the advantages and disadvantages of having an activeboard of directors? Who should sit on the board, and what shouldthe founders expect the directors to do? (Chapter 6: Forming andWorking with the Board)

10. What are the founders’ options for financing the new venture?(Chapter 7: Raising Money and Securities Regulation)

11. Does the company have to pay laboratory engineers the minimumwage and overtime? When is the company required to withholdtaxes from a worker’s check and pay Social Security taxes? Whataccommodationsmust the companymake forworkerswith physicalor mental disabilities? How should the company resolve a claim bya 41-year-old Muslim man that he was laid off because of his age,national origin, and religion, andhow can the companyprotect itselfagainst such claims in the future? How should the company resolvea sexual harassment claim brought by a male employee againsta female supervisor? (Chapter 8: Marshaling Human Resources)

12. How can Pierre and Maya ensure that the company’s customerspay on time and that its suppliers ship goods in the quantity and ofthe quality they need for the business? What should they considerbefore signing a standard-form lease for office, laboratory, ormanufacturing space? (Chapter 9: Contracts and Leases)

13. What warranties are implied when the company sells a product?Can the company disclaim all warranties and limit its liability toreplacement of the product or refund of the purchase price? Canthe company imply in its advertising that plants with largeelectricity demands can run exclusively on solar power collectedwith CadWatt Solar Cells? (Chapter 10: E-Commerce and the Salesof Goods and Services)

14. Does the company need to be concerned that the property it isconsidering leasing for manufacturing is near a river? (Chapter 11:Operational Liabilities and Insurance)

15. How should the company resolve a claim for assault, battery, andfalse imprisonment arising out of an altercation with one of the


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Notes1. See Anver Versi, Africa’s Heroic Entrepreneur (Mohamed Ibrahim) (Biogra-

phy), AFRICAN BUS., Feb. 1, 2006.

2. G. Felda Hardymon & Ann Leamon, Celtel International B.V., HBS Case No.805061 (Boston: Harvard Business School Publishing, 2004), at 5.

3. Versi, supra note 1.

4. Mark Odell, Celtel Accepts Kuwaiti Offer, FIN. TIMES, Mar. 30, 2005, at 26.

5. Alan Cowell, Prize to Honor Heroes in African Democracy, N.Y. TIMES, Oct.27, 2006, at A11.

6. See Scholarship Opportunities, available at www.moibrahimfoundation.org(under Scholarships) (last visited Feb. 27, 2010).

7. SANDRA L. KURTZIG, CEO: BUILDING A $400 MILLION COMPANY FROM THE GROUND

UP 2 (1994).

8. Id. at 2–3.

9. Id.

company’s employees, and how can the company protect itselfagainst such claims in the future? (Chapter 11: OperationalLiabilities and Insurance)

16. What happens if the company runs out of cash and cannot pay itsdebts? (Chapter 12: Creditors’ Rights and Bankruptcy)

17. If Pierre and Maya seek venture capital financing, how should theyapproach the venture community? What business and legalprovisions in the term sheet and other financing documents shouldconcern them? What is negotiable? Are any of the terms dealbreakers? (Chapter 13: Venture Capital)

18. How can the company protect its proprietary technology? Does thecompany need to worry about violating other companies’ patentsor copyrights? (Chapter 14: Intellectual Property and Cyberlaw)

19. Should the company expand beyond the United States? What arethe advantages and disadvantages of going global? (Chapter 15:Going Global)

20. What risks are involved in growing the business by acquisition? Isit better to grow the business internally? When should entrepre-neurs consider selling their business to a larger competitor?(Chapter 16: Buying and Selling a Business)

21. When is an initial public offering an appropriate exit strategy?What is involved in going public? What does it mean to be a publiccompany? (Chapter 17: Going Public)



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10. See Howard Stevenson, The Heart of Entrepreneurship, HARV. BUS. REV. 85–94(Mar.–Apr. 1985).

11. William A. Sahlman, Some Thoughts on Business Plans, in THE ENTREPRENEUR-

IAL VENTURE (Sahlman et al. eds., 2d ed. 1999).

12. See generally, CONSTANCE E. BAGLEY, WINNING LEGALLY: HOW TO USE THE LAW TO

CREATE VALUE, MARSHAL RESOURCES, AND MANAGE RISK (2005).

13. Constance E. Bagley, Winning Legally: The Value of Legal Astuteness, 33 ACAD.MGMT. REV. 378 (2008).



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