Ten essential legal tips to consider with a startup at formation
Here are ten essential legal tips for startup founders.
1. Set up your legal structure early and use cheap stock to avoid tax problems.
No small venture wants to invest too heavily in legal infrastructure at an early stage. If you are a solo founder working out of the garage, save your dollars and focus on development.
If you are a team of founders, though, setting up a legal structure early is important.
First, if members of your team are developing IP, the lack of a structure means that every participant will have individual rights to the IP he develops. A key founder can guard against this by getting everyone to sign “work-for-hire” agreements assigning such rights to that founder, who in turn will assign them over to the corporation once formed. How many founding teams do this? Almost none. Get the entity in place to capture the IP for the company as it is being developed.
Second, how do you get a founding team together without a structure? You can, of course, but it is awkward and you wind up having to make promises that must be taken on faith about what will or will not be given to members of the team. On the flip side, many a startup has been sued by a founder who claimed that he was promised much more than was granted to him when the company was finally formed. As a team, don’t set yourselves up for this kind of lawsuit. Set the structure early and get things in writing.
If you wait too long to set your structure up, you run into tax traps. Founders normally work for sweat equity and sweat equity is a taxable commodity. If you wait until your first funding event before setting up the structure, you give the IRS a measure by which to put a comparatively large number on the value of your sweat equity and you subject the founders to needless tax risks. Avoid this by setting up early and using cheap stock to position things for the founding team.
Finally, get a competent startup business lawyer to help with or at least review your proposed setup. Do this early on to help flush out problems before they become serious. For example, many founders will moonlight while holding on to full-time jobs through the early startup phase. This often poses no special problems. Sometimes it does, however, and especially if the IP being developed overlaps with IP held by an employer of the moonlighting founder. Use a lawyer to identify and address such problems early on. It is much more costly to sort them out later.
2. Normally, go with a corporation instead of an LLC.
The LLC is a magnificent modern legal invention with a wild popularity that stems from its having become, for sole-member entities (including husband-wife), the modern equivalent of the sole proprietorship with a limited liability cap on it.
When you move beyond sole member LLCs, however, you essentially have a partnership-style structure with a limited liability cap on it.
As such, the LLC can be used for some multi-member startups and offers the advantage of informality in management. If this suits your team, and if none of the impediments described in the next paragraph apply, then by all means use the LLC format.
That said, the partnership-style structure does not lend itself well to common features of a startup. It is a clumsy vehicle for restricted stock (described below) and for preferred stock. It does not support the use of incentive stock options. It cannot be used as an investment vehicle for VCs.
There are, of course, cases where an LLC does make sense for a startup (e.g., where special tax allocations make sense, where a profits-only interest is important, where tax pass-through adds value, where a simple management structure is important and no special impediment to the use of the LLC applies).
Work with a lawyer to see if special case applies. If not, go with a corporation.
3. Be cautious about Delaware.
Delaware offers few, if any advantages, for an early-stage startup. The many praises sung for Delaware by business lawyers are justified for large, public companies. For startups, Delaware offers mostly administrative inconvenience.
Some Delaware advantages from the standpoint of an insider group: (1) you can have a sole director constitute the entire board of directors no matter how large and complex the corporate setup, giving a dominant founder a vehicle for keeping everything close to the vest (if this is deemed desirable); (2) you can dispense with cumulative voting, giving leverage to insiders who want to keep minority shareholders from having board representation; (3) you can stagger the election of directors if desired.
Delaware also is an efficient state for doing corporate filings, as anyone who has been frustrated by the delays and screw-ups of certain other state agencies can attest.
On the down side – and this is major – Delaware permits preferred shareholders who control the majority of the company’s voting stock to sell or merge the company without requiring the consent of the common stock holders. This can easily lead to downstream founder “wipe outs” via liquidation preferences held by such controlling shareholders.
Also on the down side, early-stage startups incur administrative hassles and extra costs with a Delaware setup. They still have to pay taxes on income derived from their home states. They have to qualify their Delaware corporation as a “foreign corporation” in their home states and pay the extra franchise fees associated with that process. They get franchise tax bills in the tens of thousands of dollars and have to apply for relief under Delaware’s alternative valuation method. None of these items constitutes a crushing problem. Every one is an adminstrative hassle.
My advice from years of experience working with founders: keep it simple and skip Delaware unless there is some compelling reason to choose it; if there is a good reason, go with Delaware but don’t fool yourself into believing that you have gotten yourself a special prize for your early-stage startup. (For more on this topic, see What are the advantages and disadvantages of setting up a startup business in Delaware?)
If a founder gets stock without strings on it, and then walks away from the company, that founder will get a windfall equity grant. There are special exceptions, but the rule for most founders should be to grant them restricted stock, i.e., stock that can be repurchased by the company at cost in the event the founder leaves the company. Restricted stock lies at the heart of the concept of sweat equity for founders. Use it to make sure founders earn their keep.
Note that use of restricted stock can raise tricky issues. What if a founder has already done something of great value for the startup? Should that founder’s interest be put at risk of forfeiture? What if a founder is arbitrarily terminated? What protections exist for such situations?
The short answer to such questions is that restricted stock is very flexible.
Founders can set up their companies with a mix-and-match approach. With any given group of founders, some stock can be subject to forfeiture while other stock is not. Any given founder can have only a portion of that founder’s stock be made subject to forfeiture while the rest is not. Acceleration provisions can be added to founder agreements to protect against arbitrary terminations. And vesting provisions can be mixed and matched as desired, with any length or rate of vesting used as appropriate to tailor the situation to the founders’ deal.
It goes without saying, of course, that restricted stock is not for everyone, even for a founding team. Sometimes founders will find it inappropriate or will have enough trust in one another not to be concerned about anyone walking away. In such cases, plain, old unrestricted grants can be used (in such cases, though, VCs will later insist on vesting if they are brought in).
5. Make timely 83(b) elections.
When restricted stock grants are made, they should almost always be accompanied by 83(b) elections to prevent potentially horrific tax problems from arising downstream for the founders. This special tax election applies to cases where stock is owned but can be forfeited. It must be made within 30 days of the date of grant, signed by the stock recipient and spouse, and filed with the recipient’s tax return for that year.
6. Get technology assignments from everyone who helped develop IP.
When the startup is formed, stock grants should not be made just for cash contributions from founders but also for technology assignments, as applicable to any founder who worked on IP-related matters prior to formation. Don’t leave these hanging loose or allow stock to be issued to founders without capturing all IP rights for the company.
Founders sometimes think they can keep IP in their own hands and license it to the startup. This does not work. At least the company will not normally be fundable in such cases. Exceptions to this are rare.
The IP roundup should include not only founders but all consultants who worked on IP-related matters prior to company formation. Modern startups will sometimes use development companies in places like India to help speed product development prior to company formation. If such companies were paid for this work, and if they did it under work-for-hire contracts, then whoever had the contract with them can assign to the startup the rights already captured under the work-for-hire contracts. If no work-for-hire arrangements were in place, a stock, stock option, or warrant grant should be made, or other legal consideration paid, to the outside company in exchange for the IP rights it holds.
The same is true for every contractor or friend who helped with development locally. Small option grants will ensure that IP rights are rounded up from all relevant parties. These grants should be vested in whole or in part to ensure that proper consideration exists for the IP assignment made by the consultants.
7. Protect the IP going forward.
When the startup is formed, all employees and contractors who continue to work for it should sign confidentiality and invention assignment agreements or work-for-hire contracts as appropriate to ensure that all IP remains with the company.
Such persons should also be paid valid consideration for their efforts. If this is in the form of equity compensation, it should be accompanied by some form of cash compensation as well to avoid tax problems arising from the IRS placing a high value on the stock by using the reasonable value of services as a measure of its value. If cash is a problem, salaries may be deferred as appropriate until first funding.
8. Consider provisional patent filings.
Many startups have IP whose value will largely be lost or compromised once it is disclosed to the others. In such cases, see a good patent lawyer to determine a patent strategy for protecting such IP. If appropriate, file provisional patents. Do this before making key disclosures to investors, etc.
If early disclosures must be made, do this incrementally and only under the terms of non-disclosure agreements. In cases where investors refuse to sign an nda (e.g., with VC firms), don’t reveal your core confidential items until you have the provisional patents on file.
9. Set up equity incentives.
With any true startup, equity incentives are the fuel that keeps a team going. At formation, adopt an equity incentive plan. These plans will give the board of directors a range of incentives, unsually including restricted stock, incentive stock options (ISOs), and non-qualified options (NQOs).
Restricted stock is usually used for founders and very key people. ISOs are used for employees only. NQOs can be used with any employee, consultant, board member, advisory director, or other key person. Each of these tools has differing tax treatment. Use a good professional to advise you on this.
Of course, with all forms of stock and options, federal and state securities laws must be satisfied. Use a good lawyer to do this.
10. Fund the company incrementally.
Resourceful startups will use funding strategies by which they don’t necessarily go for large VC funding right out the gate. Of course, some of the very best startups have needed major VC funding at inception and have achieved tremendous success. Most, however, will get into trouble if they need massive capital infusions right up front and thereby find themselves with few options if such funding is not available or if it is available only on oppressive terms.
The best results for founders come when they have built significant value in the startup before needing to seek major funding. The dilutive hit is much less and they often get much better general terms for their funding.
These tips suggest important legal elements that founders should factor into their broader strategic planning.
As a founder, you should work closely with a good startup business lawyer to implement the steps correctly. Self-help has its place in small companies, but it almost invariably falls short when it comes to the complex setup issues associated with a startup. In this area, get a good startup business lawyer and do it right.