Ten essential legal tips to consider with a startup at formation
Here are ten essential legal tips for startup founders.
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.