I always advise software startups to file patents to protect their “secret sauce” from competitors, and to increase their valuation. The good news is that a patent can scare off or at least delay competitors, and as a “rule of thumb” every patent can add up to $1M to your startup valuation for investors, or for M&A exits (merger and acquisition).

The bad news is that patent trolls can squeeze the lifeblood out of innocent and unsuspecting entrepreneurs, as exemplified by the current mess around Lodsys patent No. 7222078. This patent holding company is charging infringement and demanding royalties from every app developer for the iPhone and Android, for a feature most agree has been in apps for many years.

Yes, the software patent process is a mess. I say this with conviction even after I survived the process, and have a software patent pending. Consider this list of commonly recognized software patent flaws, as summarized from my research, Paul Graham’s “Are Software Patents Evil?” essay, and the most recent “Enough is Enough” article by VC Fred Wilson, sparked by the Lodsys case.

• Process is onerous, expensive, and time consuming. Count on spending $10K to $20K per patent just for a USA application today, unless you do most of the work. Even after your application is accepted, the issuing process takes a lifetime in today’s technology (4-5 years). Then you need to repeat the process for every country of interest.

• Patents have become a tax on innovation. A lot of companies, like Lodsys above, buy up software patents that are over-broad, and hold startups hostage, after the fact, through royalties and litigation. They know that these entrepreneurs don’t have the skill or resources to defend themselves. Patents only help the big guys who want no change.

• Software technology changes rapidly. Software changes fast and the government moves slowly. The USPTO has been overwhelmed by both the volume and the novelty of applications for software patents, and they can’t maintain a qualified staff. Patents currently last 20 years, which is way too long in the software business.

• Patents granted that don’t meet the criteria. To be patentable, an invention has to be more than new. It also has to be “novel” and non-obvious. Moreover, patent law in most countries says that software “algorithms” aren’t patentable. So lawyers routinely frame a software algorithm as a “system and method” to meet the criteria.

• Valid patent can be overturned by unpatented prior art. The USPTO operates on the doctrine of “first to invent,” rather than first to patent. This is ugly, as it means that a valid patent can be overturned by another inventor with a preponderance of evidence of prior art. This happened to RIM (Research In Motion), and cost them nearly $650M to recover.

• Applying for a patent is a negotiation. As a result, lawyers always apply for a broader patent than they think will be granted, and the examiners reply by throwing out some of the claims and granting others. They don’t insist on something very narrow, with proper technical content.

• Different rules around the world. What I have described so far is the situation in the US. In Europe, software is already deemed not patentable, and other parts of the world are somewhere in between. In some countries, software patents are not recognized, and in others they are not enforced. We need a global solution.

So what’s the answer? I would argue to simply eliminate the software patent – since software is an implementation and is already covered by trademark and copyright law anyway. Another argument is that software by itself is information, not physical. It is in the jargon not “technical.” It is like a piece of music that is loaded into an iPod, or a record placed on a record player.

New computational technology algorithms would still be patentable, as long as the algorithm meets the defined requirements for novelty, usefulness and inventiveness. I’m a big supporter of building and protecting a portfolio of real intellectual property, and maximizing your startup’s valuation, but it shouldn’t be just a legal game.

Did you ever wonder how a new entrepreneur knows how to “do the right thing” for his business? Most experts believe that the essence of doing the right thing is ethics. Translating that into business value, a study by Wirthlin Worldwide concluded that 80% of customers still base a good portion of their buy decision on their perception of that firm’s ethics.

Ethics are generally defined as a set of societal standards that encompass the norms of the community. These norms are not genetic, and they have to be learned. At the base of these are moral values, but in my view most of the rest are gleaned from experience, parents, and formal education.

In the real world, the latest updates come from good business books, like the new one by David M. Shedd, “Build a Better B2B Business.” This one focuses on the generic attributes, as well as specific processes, which add up to the ethically right thing for most businesses.

The generics include integrity and honesty, as well as the above mentioned moral values. The specifics for business include providing leadership in building the business, but also in contributing to the greater good:

1. Communicate your values and business goals. Doing the right thing for the business starts with defining core values. Then create business goals to tackle the few critical issues and opportunities for the business. To be effective, communication has to be two-way and continuous, to keep the “right thing” as “top of mind” for all team members.
2. Align the organization to your values and goals. Ensure everyone is in alignment to live the values and focus on and execute the goals. Make the tough decisions to ensure the success and profitability of the business, and make the tough personnel decisions to put the right people in the right positions, giving them the training they need.
3. Manage priorities for the short-term as well as the long-term. Just as people must manage their personal and work responsibilities, so, too, must companies balance their priorities. Prioritize on the constraint in the business – that which is important, not on what is most urgent.
4. Endeavor to beat, not meet, industry standards. Doing the right thing is not just “getting by,” or squeezing within the letter of the law. It means knowing and living by the spirit of the law, as well as not waiting for new laws and regulations to fix problems. The same is true of employee standards, and social responsibilities.
5. Create winning teamwork. Leading people to do the right thing as a team is one of the most challenging things to teach and coach. Making a team work well requires constant communication, demonstrating accountability, ensuring motivation, recognition, and continual learning.
6. Look at yourself from your customer’s perspective. The right thing is for every business leader to value every customer and realize the importance of each in building the business. Your appreciation of your customers and focus on delivering value to them is a pre-requisite to customer satisfaction, growth, and success.
7. Balance work and life. We are all in business to be successful, but we are all people too. Another way to send a strong message about doing the right thing is to step up to the thorny “quality of life” issues, including balancing one’s work and personal life, work at home, and providing the right health, social, and spiritual needs.

Since ethical behavior is the base, the traits to foster this must always be sought out and nurtured. These traits include day-to-day work consciousness, enhanced discipline to foster a combined business and ethical acumen, and empathy for a high level of engagement. This insures that everyone is joined together, feeling a common imperative to do the right thing and make the right decisions.

So don’t assume that “doing the right thing” comes naturally, and doesn’t require any effort. Yet the evidence indicates that a startup which consistently does the right thing has a competitive edge, and a higher success rate. Are you ready and willing to take the high road for the ethics of your team and your company?

Companies today are paranoid, afraid that even their friends will steal their business. Yet a creative collaboration with your biggest competitor may be the best opportunity for revenue and survival. But remember that “dancing with the wolves” can also get you eaten for lunch. You have to take the risk, but keep your wits about you.

Your goal is “coopetition” – to find a way to partner with your competitor in such a way that both parties can substantially benefit from the other’s resources – without stealing customers or damaging anyone’s credibility. It’s a great survival strategy for small companies or entrepreneurs, and a good expansion strategy for even the largest companies.

As an example, a few years ago I worked for small software company selling an expensive enterprise workflow product. It was heavy on visual development capability but light on modeling and simulation, and we kept battling a competitor in the marketplace who had essentially the inverse strengths in a similar product. We were both losing in the lucrative high-end market segment. Neither could afford to build what the other had, but we could easily integrate some of our combined features in a shared product.

We finally decided set up a strategic partnership with a joint product to capture this elusive segment of the market. As a result of our increased coverage and wider range of solutions, we both gained revenue and credibility, while reducing marketing and development. In the following quarter, we jointly signed up two new customers who loved our “end to end” integrated solution.

This example is only the first of six approaches for coopetition, with potential wins for both sides:

1. Best of both creates a new market. Your competitor has strengths, and you have different strengths. A strategic combination can win in a new segment of the market, which neither of you could do alone in the same timeframe or at the same cost.
2. Cost sharing and economies of scale. Companies work together on segments of their business where they believe they can minimize costs but not jeopardize their unique attributes. For instance, Dell and HP are strong competitors on notebook computers, but both offer Intel processors, rather than building their own to keep component costs down and broaden their application market through compatibility. Both now lead with the same processors, but Dell offers custom system configuration at ship, while HP capitalizes on more impressive display and battery technology.
3. Up-sell related products after the initial sale. If your customers would benefit by having both of your products, you might negotiate the opportunity to include your competitor’s product as a later add-on, or vice versa. This is called up-selling, or cross-up-selling, and both parties share the profits. You see this every day in retail outlets that are not “company stores.” They are more than happy to sell you alternative brand of shoes that match your suit, or suggest a premium appliance from another manufacturer, once you have selected the lowest cost refrigerator.
4. Integrate for new or critical mass. If your competitor has a similar product that could complement your own, you might consider arranging a deal where both you and your competitor would offer an integrated bundle or new product. Another way to “coopetate” is to create a critical new offering to address a common enemy. For example, if you’re selling a travel magazine, you could add a free travel video when someone buys a subscription. You’re now targeting people who want the travel magazine and those that want the specific video you are giving away. Others will now buy your travel magazine over a travel book, for example, which competes with both your magazine and the video individually.
5. Cross endorsement.If your “competitor” isn’t really competing with your direct market, you can refer business to each other without anyone losing customers. Affiliate marketing might actually be one of the more effective (and easier) ways to partner with someone else in the industry. Online, this starts with link exchanges, leading to referral fees.This also works for two businesses with different products but similar clientele, to increase the market for both. It could be something as simple as a chiropractic office that offers acupuncture and physical therapy cross-endorsing with a neighboring gym. Gym members could get discounts on chiropractic services and chiropractic patients might get free on-site body fat analyses from the gym.
6. Possible investor. Once you have established your credibility and value, a strategic partnership may extend to a financial relationship. They may have the finances you need and are ready to invest in a business area they know. Also, this competitor will now be a better candidate for merger or acquisition (M&A), due to the existing relationship, when either of you is ready for that step. For example, IBM, Intel, and other large companies routinely allocate and manage venture funds to invest in startups with new technology that may in fact be competitive with their own. Buying the startups that get traction is cheaper and faster for them than trying to manage similar development efforts within a large company.

Of course, for a strategic alliance to work, you must take precautions. Companies need to very clearly define where they are working together and where they are competing. The right place to start with a good joint non-disclosure and non-compete agreement. Also, make sure there is no misalignment of priorities between your organizations, which can negate all the positives.  For example, if your pride is your customer service reputation, don’t risk it by partnering with a company who has related items at a lower cost but consistently poor customer service.

While it is normal to instinctively look for ways to avoid, evade or protect ourselves from the perceived threat of a competitor, take the time to look at the opportunity strategic alliances may provide. You will find that it is sometimes smarter to capitalize on the positive aspects of a competitive situation, rather than fight to the death of both of you.

Although every startup is unique, there are certain common avoidable mistakes that can lead to legal complications which jeopardize the long-term success of the business. I’m not suggesting that every startup needs a lawyer, but you should definitely pay attention, and not be afraid to consult legal counsel if any of these raise qualms for you.

Like other environments, most legal issues don’t result from fraud, but from ignorance on specific requirements, or simply never getting around to doing the things that common sense would tell you to do. Here are five of the most common examples:

1. Failure to document a founder agreement at the beginning.This oversight can lead to the so-called “forgotten founder” problem. Early co-founders often drop out of the picture due to disagreements, and you forget about them, but they don’t forget about the verbal promises you made.Later, when your venture is trying to close on financing, or even going public, that forgotten partner surfaces, demanding their original share. This problem can be avoided by incorporating immediately after early discussions, and issuing shares to the founders, with normal vesting and other participation rules.
2. Trouble with the IRS over founders stock value.Many startups delay incorporation until the first formal round of financing, which is too late. At this point your entity may already have several million in valuation, so the IRS will tax your shares at that value immediately as income, just when your cash flow is at its lowest.The solution again is to incorporate early, when founders shares clearly have trivial value, and filing an “83(b) election” with the IRS within 30 days of the agreement. Then you will only have pay tax on the increasing value of your shares when they are sold.
3. Disclosing inventions before the patent application is filed.Entrepreneurs often put off the hassle and the cost of filing a patent until first funding. Then they realize that they have talked to many people without signing non-disclosure statements, precluding a patent, or someone else has now beat them to the filing docket.There is no excuse for not filing at least a provisional patent early. This will hold your place in the patent line for a year, and the costs and time for this filing are much less. Even trade secrets need to be documented, and reasonable steps taken to keep them secret. Business plans and other documents should always be labeled as confidential.
4. Founders ignore non-compete clauses from former employers.If your new business is even remotely similar to that of your current or former employer, think hard about any written or implied non-compete agreements you might have. Do the same for every business partner or employee you may hire.The best way to short-circuit this problem is to have a frank and open discussion with former employers, perhaps under the guise of asking them to invest in your venture. This is a smooth way to end the relationship, and get some money, or get their lack of interest documented in a note back to them. If a lawsuit is inevitable, better sooner than later.
5. Promising more to investors than you can deliver. Securities fraud is a hot subject these days, especially after Bernie Madoff. It’s not a good idea to take money from anyone, even friends and family, without an experienced investment attorney drafting or reviewing the agreement to make sure it complies with federal and state securities laws.

This works to protect you from unscrupulous investors, as well as non-professional investors who may later say that your business plan was misleading. The best advice is to only take investment funds from people who can financially afford to lose, and who qualify as accredited investors.

Overall, the biggest legal mistake that a startup can make is to assume that any legal problems can be resolved later. Finding a lawyer early is easy these days, through local networking or even online services like ExpertBids. In reality, it will cost you much less to get it right the first time, when the stakes are still low, compared to the heartache and cost of correcting it later.

The official start date for your startup is the date you incorporate the business. This is obviously important for tax purposes, but may also dramatically influence how potential investors, customers, and competitors look at you.

My rule of thumb expectation is that it should take two months to set up the legal entity, six months to finalize the business plan, and by the end of the first year have a prototype product ready for customers. At this point every potential investor will listen. Timelines which vary dramatically from these will be questioned, and need to have good explanations.

For time and effort considerations, I tell clients that a sole proprietorship or partnership is the simplest setup, because it basically requires no legal forms. Incorporation as an LLC, a C-Corp or an S-Corp is more complex, but has the great legal advantage of limiting liability to the entity, away from personal assets.

A C-Corp is the most complex, and is recommended when you need multiple classes of stock, expect venture investments, or have over 100 shareholders. But even this one can be done in a month in most states.

For more specific considerations, you should consult your attorney, or at least visit one of the many sites which focus on this process. Many startups defer the incorporation decision until they have an investor lined up, but that can raise significant tax issues, as I outlined in an earlier article on founder’s stock.

Aside from the tax considerations, there is nothing wrong with tinkering and honing an idea for years (on your own funding), before you incorporate a company and take it to market. But once you incorporate the company, all measurements start and you need to keep the process moving.

Consequently, if you approach investors for funding, and they find out your company was formed five years ago, but gone nowhere due to your other activities or false starts, they will likely assume that you are a procrastinator, or worse yet, that you have failed to make progress despite your best efforts. No investment will be forthcoming, and competitors have likely closed in.

On the other end of the spectrum, remember that you only get one chance for “first impressions” with investors, So don’t rush it by trying to sell your “idea” to investors with only a verbal spiel, before you even have a company or a business plan. Save these discussions for friends, family, and trusted business advisors.

In conjunction with the timings above, here are my recommendations on the sequence of events:

1. Focus and solidify your product idea and company name before incorporating.
2. Incorporate before spending big money on development or assets to limit liability.
3. Assemble the core team for development using personal, friends, or family funding.
4. Move quickly to prepare the case for external funding, if angel investors are required.
5. Build a minimum product, add sales, and test the market quickly, then iterate.
6. Scale the business, getting venture capital funding as required.

Obviously, timings can vary dramatically when technology or regulatory constraints are involved. The key is to show everyone a record of continuing momentum. If investors or customers lose confidence in you, or you run out of cash, the momentum can stop on your startup as quickly as it starts.

Your timeline and momentum is the message you scratch in the sand for investors. Don’t let the passage of too much time blow it away.

In reality, so-called “founder’s” shares are simply common stock, issued at the time of startup incorporation, for a very low price, and normally allocated to the multiple initial players commensurate with their investment or role. But that’s only the beginning of the story.

These shares are allocated and committed, but not really issued and owned (vested) until later. Typically, vesting in startups occurs monthly over 4 years, starting with the first 25% of such shares vesting only after the employee has remained with the company for at least 12 months (one year “cliff”). Vesting always stops when an employee leaves the company.

Even though the class is common stock, founders can negotiate special vesting and other terms as part of their stock restriction agreement upon venture investment. Here are some typical special terms for founder’s stock:

• Negligible par value. Since founder’s shares are usually issued at the time the company is incorporated, they essentially have no par value. As the company builds value, shares allocated later for employees or partners will have an appropriate price.

• Vesting starts now. Most founder vesting is not subject to the one year cliff because founders should already know and trust each other. Thus, most founders will start vesting their shares from the date they actually started providing services to the company.

• Acceleration clause. They might also have special terms in the case of termination or demotion that accelerate vesting. These have less to do with the type of stock and more to do with who the person is and how strategic they are to the organization.

• Stock survives investment. While most employees would see their vesting rest when the “Series A” round closes, a founder might retain some percent of their shares. Everyone wants to minimize dilution of shares, so special clauses are often included.

Unfortunately, founders often make the mistake of waiting until they have received a strong indication of interest from an investor before they decide that it is time to incorporate. Forming a company so close in time to raising capital can create a significant tax issue.

For example, if founders issue themselves stock for one cent per share when they form the company, and then within a short period of time outside investors jump in at $1 or more per share, it might appear in an IRS audit that the founders issued themselves stock at significantly below the fair market value per share.

The difference in value between what the founders paid and the fair market value of that stock based on actual sale to outside investors will be characterized as compensation income resulting in what could be significant tax liability to the founders.

The way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your founder’s shares and paying your tax early on those shares. Failing to file the 83(b) election is common mistake of founders that you should avoid.

There should be no tax concern for a founder investing more of his own money any time in the process. All the tax concerns relate to “outside” investors coming in shortly after incorporation. Valuation has very little meaning until an outsider invests.

So my advice is to incorporate and allocate founder’s stock as soon as you are starting real work on the company, but at least six months before you anticipate any outside investors. But don’t incorporate too early, as investors will measure your growth and progress since the incorporation date. Several years of apparent inactivity since incorporation will make it look like there is a problem with you or with the company.

Of course I have to add my caveat that I’m not a lawyer, and these comments do not constitute a legal opinion. See a qualified business attorney if you anticipate multiple investors or a complex company structure. Don’t let a positive investor decision take the joy out of your future.