Earlier this month, Snap, Inc. launched its initial public offering (“IPO”) at a price that gave the company a $24 billion valuation. Snap, Inc. owns Snapchat, a mobile application that allows users to send photos to one another that automatically “disappear” after a few seconds. Less widely reported amidst the hype surrounding the IPO price, however, was that Snap, Inc. paid $158 million, prior to the IPO, to settle a lawsuit by a person claiming to be the third founder of the company. The settlement demonstrates the dangers of failing to properly resolve intellectual property, ownership, and control issues amongst founders at the outset of any new business venture.
In sum, the alleged third founder of Snap, Inc. claimed he came up with the initial concept for the application, designed the ghost logo that still appears on the application icon today, and prepared the patent for the software underlying the application. As a result, the alleged third founder claimed he owned a portion of Snap, Inc. and was therefore due a sizable portion of the Snap, Inc. shares that were about to become so valuable after the IPO. Unfortunately for Snap, Inc., these issues could have been prevented, or significantly minimized, by using the proper legal tools.
First, too much delay in forming a business entity (like a corporation or a limited liability company) can lead to legitimate disputes over business ownership. Under California law, for example, any association of two more persons to carry on a business for profit forms a partnership. (See Corp. Code section 16202.) In other words, it is not necessary for persons to form a corporation or limited liability company in order to obtain a legal ownership share in a business. Rather, the ownership share may inure automatically to any persons who associate with one another to operate a business for profit. If the founders of Snapchat had more clearly defined their ownership roles by forming a corporation or limited liability company early on, this could have resolved any disputes over whether the alleged third founder was entitled to an equity stake in the company as a partner.
Second, a common method for resolving intellectual property issues among founders of a company is to incorporate these concepts into the formation documents. In the case of Snap, Inc., the alleged third founder claimed he designed the logo for the Snapchat application, which could implicate trademark rights. The alleged third founder also claimed he created the concept underlying the Snapchat application itself, which could implicate patent rights. One option for Snap, Inc. to have prevented these disputes would be to have each founder agree they are assigning any and all intellectual rights they may have in the Snapchat logo and/or software (likely in addition to a cash contribution) to the corporation in exchange for their ownership share of the corporation. The initial capitalization table can memorialize this type of agreement and be included as an exhibit to a corporation’s bylaws (or to a limited liability company’s operating agreement).
As a result of this kind of arrangement, the corporation would own the intellectual property and the founders will, in turn, each own a portion of the corporation. In addition to minimizing intellectual property disputes among the founders, this option helps to facilitate outside investment in a company because investors will want to see that a company owns any pertinent intellectual property outright prior to making an investment in the company.
In Snap, Inc.’s case, the failure to take a few additional steps in the early stages of the company resulted in an outcome that was probably unfortunate for both sides. The $158 million settlement was bad for the two founders who are still with the company because the settlement could have been avoided had the proper legal documents been created establishing that only two persons owned the company and its intellectual property. On the other hand, the $158 million was also bad for the alleged third founder because, if he really was entitled to a portion of the company, he probably would have been due much more than that amount, given the value of the company.
For questions about corporate formation issues, please contact Patrick Klingborg in LGC’s San Diego office.