The Dilemma: You Can’t Take It. But You Don’t Think the Company Can Survive.
Imagine you’re an engineer in a company that relies heavily on the technology you’ve developed and keep developing for the company. Although you make good money from it, it’s also a labor of love for you, and you like the other engineers you work with. Then, one day, the company’s founder dies unexpectedly. He was so young! And, then, his mom takes over the company.
You might or might not be a fair-minded person. You might have given the mom the benefit of the chance to show she can manage the company. Or you might not. Either way, you and your fellow engineers think she’s not up to the task. As far as you and your fellows are concerned, the technology is withering; the company is withering; your livelihood is in jeopardy.
You want to save the technology, your livelihood and the company, in that order. What are your options? They aren’t great. Let’s consider them:
- Buy the company from the mom. This is the most elegant solution. You’d be in control of the company and the technology, and everything would be legal. There are, of course obstacles, and they might be insurmountable. You and your fellows might not be able to raise much money. Small businesses are notoriously difficult to value, and you and the mom might legitimately have differing views on the purchase price. Or the mom might not believe you are up to the task.
- Keep working or find a new job, and hope for the best. Under these circumstances, this might really be your only option, but let’s consider a popular alternative.
- Start a new business (great!) using the company’s technology (uh-oh!). You developed the technology, right? You’ve been the one that keeps it working and up to date, right? It’s sort of yours, right?
Let me dispel the tension right now and say that, if you chose the third option, you might regret it. Take a look at what’s been happening in CatalinBread LLC v. Gee, where almost the exact same thing happened. The technology in question is guitar pedals, so at least lives don’t hang in the balance. The company’s founder passed away unexpectedly, and his mother took over. The defendants in the case—all former, fairly high-level employees, including one of the key engineers—first tried to get the mom to sell them the company. That didn’t work. So they decided to form their own company that also made and sold guitar pedals.
The parties were at an impasse, and I’m not sure they realized it. On the one hand, the defendants were (allegedly) about to do something illegal. On the other hand, the mother was about to lose a lot of talent and institutional knowledge.
Eventually, it comes to the mother’s attention what the defendants are planning. Apparently, the company had access to their Slack chats, which they didn’t completely destroy? By this point, they had already copied what computer files they needed and had already left the company and were setting up shop on their own account.
It comes to a lawsuit. What choice did the mother have? You can’t just let trade secrets walk, because then they stop being trade secrets. This isn’t just “customer-lists” level stuff. This sounds like crown jewels stuff. Since this is a law blog, let’s talk about some of the claims, and how they fared when the engineers pushed back:
- Computer Fraud and Abuse Act (CFAA): The company alleged that, when the engineers started to copy computer files (in the course of taking trade secrets), they were no longer authorized to access the company’s computer system. The theory is a bit moralizing psychology: the moment the engineers decided to form their own company, they stopped being loyal employees in their hearts, and so they lost their right to access the system. The court rejects this theory and dismisses the claims. The engineers were still employees and still had authorization. What was in their hearts doesn’t matter—for this claim, at least.1Also, taking files didn’t damage the system, and a CFAA claim requires a showing of damage. That the files were valuable is irrelevant. The focus on damage to the system, not to the company overall.
- Misappropriation of Trade Secrets: This claim survives. Not really surprising.
- Breach of the Duty of Loyalty: Ah, this is where it matters what was in the engineer’s hearts. Employees owe their employers loyalty, and the higher up in the hierarchy the employee is, the greater the duty. The defendants didn’t attack this claim at this early stage, but generally one has some leeway to form competing businesses even while employed, but it varies from state to state and can be fuzzy.
There are also some lame fraud, “tortious interference” and similar state claims. But the trade secrets claim and the duty of loyalty claim are enough for the company’s purposes. And, yet, they aren’t. Even if the company scores a flawless victory—unlikely, since individual defendants only have so much money for damages—damage already been done that the law simply cannot remedy. While the trade secrets would be back under the company’s control, it would still lose the defendants’ knowhow and institutional knowledge.
Assuming that the founder didn’t intend for his mother to take over the company, then the dispute never have come close to getting to this point. How did the founder’s mother wind up running the company? I’m betting it’s because (1) the founder owned a controlling stake in the company, perhaps even 100%, and (2) he died without a will. In the founder’s state, parents inherit if the deceased was unmarried and had not children. But even if he had been married or had children, you risk the same thing: someone with no interest or capability to run the company.
But having a will doesn’t really solve the problem (though it would solve a lot of other unrelated problems). You’d want your heirs to benefit from the value of your business, right? The problem is you might not want your heirs to actually run the business. To solve the problem, the founder needed to address a post-founder future in the operating agreement.
An operating agreement is a control among the owners (technically, “members”) of a limited liability company (LLC). It governs how money is distributed, how power is shared, and so forth. A key provision in any competent operating agreement addresses what happens if an owner leaves the company (including, alas, by unexpected death). And another key provision addresses what happens if someone unexpectedly ends up a share of the company. There are number of ways to cook these particular eggs: a variation of a “buy-sell” provision (elegant but not always fair); the use of a neutral party to value the company as part of a forced but fair sale (fair but cumbersome); or re-allocation of voting rights so only certain owners may steer the company but without diluting the other owners.
Another problem might lay in the ownership structure itself. In our hypothetical, the founder might have founded the company himself and have been a 100% owner. But as quality engineers joined the firm, it might have been wise to make them and other key employees part owners. Not only would this help with loyalty, but it would make sure someone with institutional knowledge had an ownership stake when the founder died or became disabled. Again, there are ways to draft the operating agreement that would enable this sort of strategy.
As for Catalinbread, it appears the founder was the 100% owner, and the company grew beyond what a simple single-member LLC set-up could handle.
One final thought: what about the technology? A very real possible outcome here is that the company succeeds in stopping the former employees, but the loss of talent and institutional knowledge is fatal to the company, which dies a slow death. By the time is goes bankrupt or winds down, no one remembers the company or its technology, and the ex-employees (who would have been first in line to buy the technology) have moved too far on to care. Or the technology is so neglected during the company’s slow death that it loses too much of its value. In this way, promising technology could wither away.
On that happy note, thanks for reading!
Footnotes
| ↑1 | Also, taking files didn’t damage the system, and a CFAA claim requires a showing of damage. That the files were valuable is irrelevant. The focus on damage to the system, not to the company overall. |
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