FAQ Startup

Some common questions asked by entrepreneurs setting up or operating a small business (though of interest to startup business entrepreneurs as well):

blank
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.

Conclusion

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.

Distinctive legal aspects of forming a startup business with a founding team.

Introduction

A startup with a founding team requires a special kind of company formation that differs from that used by a conventional small business in several key ways. Below, I identify and explain these differences so that founders can avoid mistakes in doing their setup.

Attributes of a Typical Startup Business

A startup is a type of small business, of course, and its founders want to make substantial and long-term profits just as any small business does. Perhaps some of the empty “concept companies” of the bubble era did not ever intend to build for long-term value but that era is over. Today’s startups need to build value in a sustainable market or fail, just like any other business. Nonetheless, a startup that is anything other than a solo effort does differ strikingly from a conventional small business. Why? Not because the enterprise itself has any different goal other than that of building long-term and sustainable value but because of how its founders view their short-term goals in the venture.

Unlike a small business, a startup founding team will adopt a business model designed to afford the founders a near-term exit (typically 3-5 years) with an exceptionally high return to them if the venture is successful. The team will often want stock incentives that are generally forfeitable until earned as sweat equity. It will typically want to contribute little or no cash to the venture. It will often have valuable intangible IP that the team has developed in concept and likely will soon bring to the prototype stage. It frequently encounters tricky tax issues because the team members will often contribute services to the venture in order to earn their stock. It seeks to use equity incentives to compensate what is often a loose group of consultants or initial employees, who typically defer/skip salary. And it will seek outside funding to get things going, initially perhaps from “friends and family” but most often from angel investors and possibly VCs. The venture will then be make-or-break over the next few years with a comparatively near-term exit strategy always in view for the founding team as the hope of a successful outcome.

The blueprint here differs from that of a conventional small business, which is often established by its founders with substantial initial capital contributions, without emphasis on intellectual property rights, with their sights fixed primarily on making immediate operating profits, and with no expectation of any extraordinary return on investment in the short term.

Given these attributes, company formation for a startup differs significantly from that of a small business. A small business setup can often be simple. A startup setup is much more complex. This difference has legal implications affecting choice of entity as well as structural choices made in the setup.

Startups Generally Need a Corporate as Opposed to an LLC Setup

An LLC is a simple and low-maintenance vehicle for small business owners. It is great for those who want to run their business by consensus or under the direction of a managing member.

What happens to that simplicity when the LLC is adapted to the distinctive needs of a startup? When restricted units are issued to members with vesting-style provisions? When options to buy membership units are issued to employees? When a preferred class of membership units is defined and issued to investors? Of course, the simplicity is gone. In such cases, the LLC can do pretty much everything a corporation can do, but why strain to adapt a partnership-style legal format to goals for which the corporate format is already ideally suited? There is normally no reason to do so, and this is why the corporate format is usually best for most founding teams deploying their startup.

A couple of other clinkers inject themselves as well: with an LLC, you can’t get tax-advantaged treatment for options under current federal tax laws (i.e., nothing comparable to incentive stock options); in addition, VCs will not invest in LLCs owing to the adverse tax hit that results to their LP investors.

LLCs are sometimes used for startup ventures for special cases. Sometimes founders adopt a strategy of setting up in an LLC format to get the advantages of having a tax pass-through entity in situations where such tax treatment suits the needs of their investors. In other cases, a key investor in the venture will want special tax allocations that do not track the investors percentage ownership in the venture, which is attainable through an LLC but not through a corporation. Sometimes the venture will be well-capitalized at inception and a founder who is contributing valuable talents but no cash would get hit with a prohibitive tax on taking significant equity in the company – in such cases, the grant of a profits-only interest to such a founder will help solve the founder’s tax problem while giving that founder a rough equivalent of ownership via a continuing share of operating profits.

In spite of such exceptional cases, the corporate format is overwhelmingly favored for startups because it is robust, flexible, and well-suited to dealing with the special issues startups face. We turn to some of those issues now.

Restricted Stock Grants – Rare for Small Business – Are the Norm for Startups with Founding Teams

An unrestricted stock grant empowers the recipient of such stock to pay for it once and keep it forever, possibly subject to a buy-back right at fair market value. This is the norm for a small business; indeed, it is perhaps the major privilege one gets for being an entrepreneur. It may not be worth much in the end, but you definitely will own it!

Unrestricted grants can be problematic in a startup, however. If three founders (for example) form a startup and plan to make it successful through their personal efforts over a several-year period, any one of them who gets an unrestricted grant can simply walk off, keep his or her equity interest, and have the remaining founders effectively working hard for a success to which the departing founder will contribute little or nothing.

Note that a conventional small business usually does not face this risk with anywhere near the acuity of a startup. Co-owners in a conventional small business will often have made significant capital contributions to the business. They also will typically pay themselves salaries for “working the business.” Much of the value in such businesses may lie in the ability to draw current monies from it. Thus, the chance for a walk-away owner to get a windfall is much diminished; indeed, such an owner may well be severely prejudiced from not being on the inside of the business. Such a person will occupy the no-man’s land of an outside minority shareholder in a closely held corporation. The insiders will have use of his capital contribution and will be able to manipulate the profit distributions and other company affairs pretty much at will.

In a startup, the dynamic is different because the main contribution typically made by each founder consists of sweat equity. Founders need to earn their stock. If a founder gets a large piece of stock, walks away, and keeps it, that founder has gotten a windfall. This risk is precisely what necessitates the use of so-called “restricted” stock for most startups. With restricted stock, the founders get their grants and own their stock but potentially can forfeit all or part of their equity interest unless they remain with the startup as service providers as their equity interest vests progressively over time.

The Risk of Forfeiture Is the Defining Element of Restricted Stock

The essence of restricted stock is that it can be repurchased at cost from a recipient if that person ceases to continue in a service relationship with the startup.

The repurchase right applies to x percent of a founder’s stock as of the date of grant, with x being a number negotiated among the founders. It can be 100 percent, if no part of that founder’s stock will be immediately vested, or 80 percent, if 20% will be immediately vested, or any other percentage, with the remaining percentage deemed immediately vested (i.e., not subject to a risk of forfeiture).

In a typical case, x equals 100 percent. Thereafter, as the founder continues to work for the company, this repurchase right lapses progressively over time. This means that the right applies to less and less of the founder’s stock as time passes and the stock progressively vests. Thus, a company may make a restricted stock grant to a founder with monthly pro rata vesting over a four-year period. This means that the company’s repurchase right applies initially to all the founder’s stock and thereafter lapses as to 1/48th of it with every month of continuing service by that founder. If the founder’s service should terminate, the company can exercise an option to buy back any of that founder’s unvested shares at cost, i.e., at the price paid for them by the founder.

“At cost” means just that. If you pay a tenth of a penny ($.001) for each of your restricted shares as a founder, and get one million shares, you pay $1,000. If you walk away from the startup immediately after making the purchase, the company will normally have the option to buy back your entire interest for that same $1,000. At the beginning, this may not matter much.

Now let us say that half of your shares are repurchased, say, two years down the line when the shares might be worth $1.00 each. At that time, upon termination of your service relationship with the company, the company can buy up to 500,000 shares from you, worth $500,000, for $500. In such a case, the repurchase at cost will result in a forfeiture of your interest.

This forfeiture risk is what distinguishes a restricted-stock buy-back from a buy-back at fair market value, the latter being most often used in the small business context.

Restricted Stock Can Be Mixed and Matched to Meet the Needs of a Startup

Restricted stock need not be done all-or-nothing with respect to founder grants.

If Founder A has developed the core IP while Founder B and Founder C are just joining the effort at the time the company is formed, different forms of restricted stock grants can be made to reflect the risk/reward calculations applying to each founder. Thus, Founder B might get a grant of x shares that vest ratably over a 48-month period (at 1/48th per month), meaning that the entire interest can be forfeited at inception and less-and-less so as the repurchase right of the company lapses progressively over time while Founder B performs services for the company. Likewise for Founder C, though if he is regarded as more valuable than Founder B, he might, say, have 20% of his grant immediately vested and have only the remainder subject to a risk of forfeiture. Founder A, having developed the core technology, might get a 100% unrestricted grant with no part of his stock subject to forfeiture – or perhaps a large percentage immediately vested with only the balance subject to forfeiture.

The point is that founders have great freedom to mix and match such grants to reflect varying situations among themselves and other key people within the company. Of course, whatever the founders may decide among themselves, later investors may and often do require that all founders have their vesting provisions wholly or partially reset as a condition to making their investment. Investors most definitely will not want to watch their investments go into a company that thereafter has key founders walking away with large pieces of unearned equity.

Restricted Stock Requires an 83(b) Election in Most Cases

In an example above, we spoke of a $500 stock interest being worth $500,000 two years into the vesting cycle of a founder, with two years left to go for the remainder. If a special tax election – known as an 83(b) election – is not properly filed by a recipient of restricted stock within 30 days of the date of his or her initial stock grant, highly adverse tax consequences can result to that recipient.

In the example just cited, without an 83(b) election in place, the founder would likely have to pay tax on nearly $500,000 of income as the remaining stock vests over the last two years of the cycle. With an 83(b) election in place, no tax of any kind would be due as a result of such vesting (of course, capital gains taxes would apply on sale).

Tax issues such as this can get complex and should be reviewed with a good business lawyer or CPA. The basic point is that, if an equity grant made in a startup context is subject to potential forfeiture (as restricted stock would be), 83(b) elections should be made in most cases to avoid tax problems to the recipients.

Restricted Stock Grants Are Complex and Do Not Lend Themselves to Legal Self-Help

Restricted stock grants are not simple and almost always need the help of a lawyer who is skilled in the startup business field.

With restricted stock, complex documentation is needed to deal with complex issues. This is why the LLC normally does not work well as a vehicle for startup businesses. The value of the LLC in the small business context lies in its simplicity. Entrepreneurs can often adapt it to their ends without a lot of fuss and without a lot of legal expense. But the LLC is ill-suited for use with restricted grants without a lot of custom drafting. If your startup is not going to impose forfeiture risks on founders or others, by all means consider using the LLC as a vehicle. If, however, forfeiture risks will be in play and hence restricted stock will be used (among other tools), there likely is no special benefit in using the LLC. In such cases, it is usually best to use a corporate format and a good business lawyer to assist in implementing the setup.

Startups Also Use Other Equity Incentives Besides Restricted Stock

Unlike a conventional small business, a typical business startup will want to offer other equity incentives to a broad range of people, not just to founders. For this purpose, an equity incentive plan is often adopted at inception and a certain number of shares reserved to it for future issuance by the board of directors.

Equity incentive plans usually authorize a board of directors to grant restricted stock, incentive stock options (ISOs), and non-qualified stock options (NQOs). Again, complex decisions need to be made and a qualified lawyer should be used in determining which incentives are best used for which recipients. In general, though, restricted stock is normally used for founders and very key people only; ISOs can be used for W-2 employees only; NQOs can be used for W-2 employees or for 1099 contractors. Lots of issues (including securities law issues) arise with equity incentives – don’t try to handle them without proper guidance.

Make Sure to Capture the IP for the Company

All too many startups form their companies only after efforts have been well under way to develop some of the key IP. This is neither good nor bad – it is simply human nature. Founders don’t want to focus too much on structure until they know they have a potentially viable opportunity.

What happens in such cases is that a good number of individuals may hold rights in aspects of the intellectual property that should properly belong to the company. In any setup of a startup, it is normally imperative that such IP rights be captured for the benefit of the company.

Again, this is complex area, but an important one. Nothing is worse than having IP claims against the company pop up during the due diligence phase of a funding or an acquisition. IP issues need to be cleaned up properly at the beginning. Similarly, provision needs to be made to ensure that post-formation services for the company are structured so as to keep all IP rights in the company.

Don’t Forget the Tax Risks

Startups have very special tax considerations at inception owing to the way they typically are capitalized – that is, with potentially valuable IP rights being assigned, and only nominal cash being contributed, to the company by founders in exchange for large amounts of founders’ stock.

Tax complications may arise if the founders attempt to combine their stock grants of this type along with cash investments made by others.

Let’s assume that two people set up a company in which they each own 50% of the stock, and they make simultaneous contributions, one of not-yet-commercialized IP rights and the other of $250,000 cash. Because the IRS does not consider IP rights of this type to be “property” in a tax sense, it will treat the grant made to the founder contributing such rights as a grant made in exchange for services. In such a case, the grant itself becomes taxable and the only question is what value it has for determining the amount of taxable income earned by the founder as a result of the transaction.

In our example, the IRS could conceivably argue that, if an investor were willing to pay $250,000 for half of a company, then the company is worth $500,000. The founder who received half of that company in exchange for a “service” contribution would then realize taxable income of $250,000 (half the value of the company). Another argument might be that the IP rights really didn’t have value as yet, but in that case the company would still be worth $250,000 (the value of the cash contributed) and the founder assigning the IP rights would potentially be subject to tax on income of $125,000 (half the value of the company, owing to his receipt of half the stock).

There are various workarounds for this type of problem, the main one being that founders should not time their stock grants to coincide in time with significant cash contributions made by investors.

The point, though, is this: this again is a complex area and should be handled with the help of a qualified startup business lawyer. With a business startup, watch out for tax traps. They can come at you from surprising directions.

Conclusion

All in all then, a startup has very distinctive setup features – from forfeiture incentives to IP issues to tax traps. It typically differs significantly from a conventional small business in the way it is set up. The issues touched upon here illustrate some of the important differences. There are others as well. If you are a founder, don’t make the mistake of thinking you can use a do-it-yourself kit to handle this type of setup. Take care to get a good startup business lawyer and do the setup right.

Advantages and disadvantages of setting up a startup business in Delaware.

The Issue for Founders

Founders of startup businesses need to decide whether to incorporate in Delaware or in the state in which they will be conducting business. In spite of the commonly held lawyer view to the contrary, I believe founders should think long and hard before choosing Delaware since it often is not the best choice for a typical early-stage startup company.

Many Startup Business Lawyers Routinely Recommend Delaware

During the high-tech bubble in the late 1990s and early 2000s, the idea of a quick path to an initial public offering became so entrenched that startups began skipping the step of incorporating in their own states and moved directly to a Delaware incorporation to speed up the process of going public. The bubble burst but this practice did not.

So what do we have? The impetus that drove lawyers to use Delaware routinely for startups was to shorten the path to IPO. After Sarbanes-Oxley and certain public accounting rules changes, very few startups any longer go the IPO route. Yet the Delaware filing pattern persists.

Let us consider the advantages of a Delaware incorporation versus the disadvantages to see if it makes sense for startups to file routinely in Delaware as many lawyers urge them to do.

Why VCs Favor Delaware

Delaware law affords substantial advantages and is an ideal state of domicile for public companies and late-stage startups that are about to go public. Delaware has a well-developed and reasonably consistent body of corporate law with which most business lawyers are familiar. It offers various advantages that help shield an entrenched management – such as the ability to dispense with cumulative voting for directors and the ability to stagger the election of directors. Owing to these advantages, Delaware is favored by venture capital investors who typically do control their portfolio companies and who prefer to make that control as complete as possible. Public company managements like Delaware for this reason as well.

Delaware law also typically gives preferred stock investors with voting control of a corporation the unilateral power to merge that entity into another, or otherwise have it get acquired, without need for approval of the founders or other early-stage participants who typically own most of the common stock. This type of transaction can “wipe out” the value of the common stock because it can be structured so that only those who hold a liquidation preference (i.e., the preferred stockholders) get any economic value out of it while the remaining shareholders may get little or nothing. In Delaware, unlike other states such as California, those who stand to get nothing out of such deals often have no voice in stopping them. Thus, there is good reason why preferred stock investors (i.e., VCs) will tend to favor Delaware corporations. It gives them enormous leverage over the remaining shareholders in the event the VCs decide to “take out” the company.

Here is a real-world illustration of how this can work. A few years back, when the tech bubble burst, our firm was working side by side with lawyers from a prestigious Silicon Valley startup venture firm on some joint client matters. During a lengthy phase, we could never get hold of the senior associate from the big firm who was working with us – he was doing an endless stream of “mergers” for weeks on end. Why, as everything around us was coming crashing down, would there be a rash of mergers? Not because these were success cases. They were not. What was happening was a systematic shedding of portfolio companies by the VC firms with quickie mergers as the vehicle. The dreams of many founders fell fast and fell hard in those short weeks.

Thus, the startup world as dominated by VCs had evolved. Before the high-tech bubble, the typical approach was for startups to incorporate in their home states and only reincorporate in Delaware when they reached a mature stage at which the advantages of Delaware law made a substantive difference to them – that is, on the eve of IPO. In the post-bubble era, the VC preference is universally for Delaware, even from inception.

Founder Concerns About VC Expectations

So where does this leave founders who need to decide where to incorporate their startup?

Founders need to understand how all this works and then make the decision that is best for them without regard to what they believe VCs will think.

Sometimes founders want to incorporate in Delaware precisely because they believe that the venture capitalists who will be funding the company later will insist on it. Some venture capitalists do, some do not, and many startups will never seek venture capital funding in any event.

Converting to a Delaware corporation from California (or another state) is not difficult and not particularly costly in the context of a VC funding round. So, worse comes to worst, if you are unable to negotiate with your VC to remain in your original state of incorporation, you can always move to Delaware as part of your funding round.

But the truth is, in over three decades of representing tech startups, at no point have I seen a VC firm refuse to fund a quality startup in which it was otherwise interested simply because it was not incorporated in Delaware. In other words, during the early funding stages of a startup, most VCs are no more consciously focused on the downstream factors of what happens during a merger than are the founders. They may be told by their lawyers of the key factors but they then need to decide whether to invest in a company that is incorporated somewhere besides Delaware. In all the cases I have seen, they have chosen to invest without regard to the Delaware factor and, indeed, have further chosen to keep the company incorporated in its home state thereafter unless and until it reached a stage where it would want to go IPO. Based on this experience, I would say that the fear factor among founders about VC expectations on this point is almost universally misplaced or at least much overstated.

Factors Affecting a Founder’s Decision Whether to Choose Delaware

For the typical California-based early-stage startup, Delaware normally does not offer any practical advantages over a California incorporation (to pick as an example the local jurisdiction of Silicon Valley). Perhaps the only near-term advantages are (1) that Delaware allows for a single-member board of directors, regardless of the number of shareholders in the company, where a state like California requires that the number of directors match the number of shareholders up to three, and (2) quicker and more reliable filing of documents in connection with funding events.

The first of these can facilitate easier corporate governance in an early-stage startup, especially a startup controlled by one predominant founder.

The second can avoid sometimes embarrassing delays when fundings are set to close.

Apart from these areas, however, a Delaware domicile normally just adds administrative burdens for an early-stage startup based in a state like California. These burdens include the difference in the way franchise taxes are handled and the need to qualify as a foreign corporation in the local state. There are also downstream risks to founders in connection with losing the value of their interests in mergers without having a voice in the process (discussed above). In general, then, a Delaware domicile imposes more administrative hassle upon an early-stage company than would a local domicile and may create substantive risks down the road for the founding team. The burdens can be dealt with, but the question is whether they are worth the meager advantages, if any, afforded by a Delaware domicile in the early stage.

The major advantage to incorporating in your local state is simplicity. In an early-stage startup, keeping matters simple is important. It saves expenses and does not divert company resources toward issues that can be avoided.

So Why Does the “Prevailing Wisdom” Say to Incorporate in Delaware?

Because the VCs want it that way. We live in a world where the “prevailing wisdom” for tech startups in terms of all things legal is what the large (mostly Silicon Valley) law firms counsel their startup clients to do. These law firms don’t make their real money on early-stage startups. They make their money representing VCs, who (unlike startups) provide substantial repeat business. Large law firms are not going to advise their clients to adopt a structure that would disadvantage the firms’ VC client base. So, they tell their startup clients from day one to choose the most VC-friendly structure.

Use Caution in Choosing Delaware

The point is not to avoid Delaware but rather to consider the issues in light of your company’s goals and not choose Delaware reflexively. At that point, check with a good lawyer and make your best call, whether it be Delaware or not. Just remember: if you choose to go simple and stay at home, and this proves in retrospect not to be your best choice, you can always reincorporate in Delaware later.

What distinguishes your “founders’ firm” from large law firms offering startup business legal services?

Founders’ firm

What is an 83(b) election and how does it work in practice?

Introduction

Founders in a startup ought to have a working knowledge of the 83(b) election and this faq seeks to give it to them.

This is a complex tax area and what is presented here is intended only to give a general picture of how 83(b) works. Work with skilled tax professionals in this area to avoid the landmines.

Here is the working rule for founders: 83(b) applies only where a founder owns stock and can potentially forfeit its economic value. Where these conditions exist, it is normally vital that a founder file the 83(b) election within 30 days of getting the stock grant or face potentially bad tax consequences.

That’s the general picture. The tax theory and a more detailed explanation follows.

IRC Section 83 Applies to Service Providers Who Receive Property in Exchange for Services

Section 83(b) is part of Internal Revenue Code section 83, which specifies how service providers who receive property in exchange for their services are to be taxed on the value of that property.

Section 83(b) is intimately connected with section 83(a) and works really only to modify certain tax consequences that would otherwise apply to service providers under 83(a).

Therefore, 83(b) cannot really be understood without a basic understanding of 83(a).

Section 83(a) Specifies How and When Such Service-Related Income Is Taxed

Under 83(a), if I get property in exchange for my services, I pay tax on the excess of the fair market value of that property over what I paid for it.

Section 83(a) applies, then, to service providers who take property as payment for services. Who is the major service provider in a startup? No, it is not the outside consultant. It is the founder who works for sweat equity.

But let us take the cases in sequence.

If I am a consultant, and I get $5,000 worth of stock for my work done for a startup, I pay tax on $5,000 worth of service income – that is, on the difference between the worth of the stock ($5,000) and what I paid for it ($-0-). That difference is taxable to me.

So far so good. That much is intuitive.

But 83(a) is more complex than that.

The founder who has to earn his shares over time is also treated by the IRS as a service provider under 83(a). The founder may pay nominal cash for the shares and may own them, but as long as that ownership can be forfeited when the founder’s service relationship to the startup is terminated, the IRS sees the stock as having been granted in exchange for services.

Thus, founder grants that must be earned out (i.e., are subject to a risk of forfeiture) fall within and are subject to tax under 83(a).

But 83(a) does not impose an immediate tax on such grants at the time they are made. It has a special rule that taxes such grants only when they are no longer subject to a “substantial risk of forfeiture.”

It is this special rule that creates traps for the unwary in the startup context.

The Nightmare Tax Scenario for Founders

Let’s assume that a founder is granted 2 million shares at $.001 per share and pays $2,000 for them. The shares vest ratably over 4 years at the rate of 1/48th per month. How does 83(a) apply to this scenario? Under 83(a), the tax authorities see the grant initially as being 100% “subject to a substantial risk of forfeiture.” Thus, no tax arises at the outset. But what then happens each month as 1/48th of the shares vest? Well, those shares are no longer subject to any risk of forfeiture as they vest. Under 83(a), then, each incremental vesting event creates a potentially taxable event for the founder holding such shares.

The risks to the founder may be slight at first when the stock remains priced by the company at the $.001 per share level. But what happens on first funding? Of course, the price of the stock goes up, often dramatically. Let’s say, after a Series A round, the company prices its common stock at $.20 per share. Once that happens, under 83(a) the founder holding the original grant is required to pay tax at each of his vesting points.

How is he taxed? On the difference between the then fair market value of the stock which has just vested (because the forfeiture restrictions lapsed as to that stock), on the one hand, and the price he paid for that stock, on the other. In our example, this would mean the founder realizes taxable income on the difference between $.20 per share and $.001 per share for each of the shares that vest each month. If another funding occurs, and the common stock is re-priced to $1.00 per share, then all of the founder’s shares that vest after that re-pricing event trigger a tax on the difference between $1.00 per share and $.001 per share. In other words, the founder finds himself in the middle of a potential tax nightmare. With each of his multiple remaining vesting points, he faces a new and potentially large tax hit. He would have 12 taxable events during the final year alone of his vesting cycle and (assuming the common stock were valued at $1.00 per share during that period) would realize taxable income of just a shade under $500,000 – all for the privilege of holding a piece of paper which he could not liquidate even if he tried!

With this background, we can understand the importance and the essence of an 83(b) election.

Section 83(b) Comes to the Rescue

While 83(a) sets out the general rules for how service providers are taxed when they exchange services for stock, 83(b) gives them an out from the nightmare tax scenario just noted.

Under 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can make a one-time election to have his entire interest taxed once-and-for-all at inception instead of having it taxed incrementally over time as the restrictions on forfeiture lapse.

This means that, if the founder mentioned above makes a timely 83(b) election on his 2 million share grant, he elects to pay tax on the difference, as of the date of grant, between the fair market value of the property received (i.e., the stock, valued at $.001 per share), on the one hand, and the amount he paid for it ($.001 per share), on the other. In other words, the founder will pay tax on the difference between the $2,000 that the stock is worth and the $2,000 he paid for it. Since there is no difference between the two, the tax is $-0-. This 83(b) process is in lieu of the 83(a) treatment that would otherwise apply and eliminates the nightmare tax scenario discussed above.

With the 83(b) election once made, the founder pays no tax on the grant at inception and incurs no taxable income as the shares vest over time. His holding period commences at inception for capital gains purposes and the only tax that would apply to such shares would be a capital gains tax at the time of sale.

So much for theory.

Tips for How 83(b) Applies in Practice

What does this mean in practice for founders?

1. Many founders routinely assume they need to do 83(b) filings in connection with their stock grants because “that is how startups work.” In fact, 83(b) filings are only required in cases where the founder grants consist of so-called “restricted stock,” which is a form of stock where the founder’s stock is subject to forfeiture on termination of his service relationship with the company.

2. If unrestricted stock grants are made to founders or others, 83(b) elections do not apply because the stock is not subject to a substantial risk of forfeiture.

3. While not often used in startups, in conventional buy-sell agreements, if a company can buy back even the vested stock of a departing founder at its fair market value on termination of a service relationship, 83(b) doesn’t apply. If the buy-back is at fair market value, there is no substantial risk of forfeiture of the economic value of the stock. Thus, no 83(b) filing is necessary.

4. When a startup grants stock options to its key people, vesting is almost invariably used. Options in themselves are subject to a complex set of tax rules but 83(b) has no bearing on any of them except for one special case. If options are granted to key people who are given the right to exercise them early, and such right is in fact exercised, such recipients will get stock that is subject to forfeiture in the event they do not earn it out through a prescribed period of service. Because of the risk of forfeiture, an 83(b) election needs to be filed at the time such options are exercised or these recipients may wind up being taxed incrementally at every vesting point, just as described in the example above with the founder. Apart from this special case of early-exercise options, 83(b) does not apply to stock options.

5. Not every 83(b) election will wind up benefitting the service provider. Sometimes an employee in a mature startup is granted restricted stock at a steeply discounted price and that employee, by filing an 83(b) election, elects to pay an immediate tax on the spread between the market value of the stock and the discounted price paid. During the bubble era, such grants were often made anticipating that the recipient would profit after a company went public. In such a case, the recipient may wind up paying a substantial tax in connection with making the 83(b) election – a tax paid, in essence, for the privilege of holding a piece of paper. If the company then fails, the 83(b) election in such a case can lead to payment of a gratuitously high tax for nothing (a tax payment which is not deductable either). An 83(b) election needs to be made very carefully whenever a significant tax becomes due upon its making.

6. Procedurally, an 83(b) election must be made within 30 days of the date of grant. This is done by a filing with the IRS. The election must be signed by the recipient and any spouse. The taxpayer must also file a copy of the 83(b) election with his tax return for that year. These rules are strict and must be complied with to the letter.

Conclusion – Use Professionals to Help You Do It Right

That ends our tour for the benefit of giving the founder a bird’s-eye view of the 83(b) election. Again, this is by no means complete and nothing is safe in this area unless done under the supervision of a good business attorney. Use this for your working knowledge and then make sure to do it right by working with competent professionals to help you implement the key steps.

What is restricted stock and how is it used in my startup?

Startup Law 101 Series – What is restricted stock and how is it used in my startup?

What Is Restricted Stock?

Restricted stock is the main mechanism by which a founding team will make sure that its members earn their sweat equity. Being fundamental to startups, it is worth understanding. Let’s see what it is.

Restricted stock is stock that is owned but can be forfeited if a founder leaves a company before it has vested.

The startup will typically grant such stock to a founder and retain the right to buy it back at cost if the service relationship between the company and the founder should end. This arrangement can be used whether the founder is an employee or contractor in relation to services performed.

With a typical restricted stock grant, if a founder pays $.001 per share for restricted stock, the company can buy it back at $.001 per share.

But not forever.

The buy-back right lapses progressively over time.

For example, Founder A is granted 1 million shares of restricted stock at $.001 per share, or $1,000 total, with the startup retaining a buy-back right at $.001 per share that lapses as to 1/48th of the shares for every month of Founder A’s service tenure. The buy-back right initially applies to 100% of the shares made in the grant. If Founder A ceased working for the startup the day after getting the grant, the startup could buy all the stock back at $.001 per share, or $1,000 total. After one month of service by Founder A, the buy-back right would lapse as to 1/48th of the shares (i.e., as to 20,833 shares). If Founder A left at that time, the company could buy back all but the 20,833 vested shares. And so on with each month of service tenure until the 1 million shares are fully vested at the end of 48 months of service.

In technical legal terms, this is not strictly the same as “vesting.” Technically, the stock is owned but can be forfeited by what is called a “repurchase option” held by the company.

The repurchase option can be triggered by any event that causes the service relationship between the founder and the company to end. The founder might be fired. Or quit. Or be forced to quit. Or die. Whatever the cause (depending, of course, on the wording of the stock purchase agreement), the startup can normally exercise its option to buy back any shares that are unvested as of the date of termination.

When stock tied to a continuing service relationship can potentially be forfeited in this manner, 83(b) election normally needs to be filed to avoid adverse tax consequences down the road for the founder.

How Is Restricted Stock Used in a Startup?

Restricted stock usually makes no sense for a solo founder unless a team will shortly be brought in.

For a team of founders, though, it is the rule as to which there are only occasional exceptions.

Even if founders do not use restricted stock, VCs will impose vesting on them at first funding, perhaps not as to all their stock but as to most. Investors can’t legally force this on founders but will insist on it as a condition to funding. If founders bypass the VCs, this of course is not an issue.

Restricted stock can be used as to some founders and not others. There is no legal rule that says each founder must have the same vesting requirements. One can be granted stock without restrictions of any kind (100% vested), another can be granted stock that is, say, 20% immediately vested with the remaining 80% subject to vesting, and so on. All this is negotiable among founders.

Vesting need not necessarily be over a 4-year period. It can be 2, 3, 5, or any other number that makes sense to the founders.

The rate of vesting can vary as well. It can be monthly, quarterly, annually, or any other increment. Annual vesting for founders is comparatively rare as most founders will not want a one-year delay between vesting points as they build value in the company. In this sense, restricted stock grants differ significantly from stock option grants, which often have longer vesting gaps or initial “cliffs.” But, again, this is all negotiable and arrangements will vary.

Founders can also attempt to negotiate acceleration provisions if termination of their service relationship is without cause or if they resign for good reason. If they do include such clauses in their documentation, “cause” normally should be defined to apply to reasonable cases where a founder is not performing proper duties. Otherwise, it becomes nearly impossible to get rid of a non-performing founder without running the risk of a lawsuit.

All service relationships in a startup context should normally be terminable at will, whether or not a no-cause termination triggers a stock acceleration.

VCs will normally resist acceleration provisions. If they agree to them in any form, it will likely be in a narrower form than founders would prefer, as for example by saying that a founder will get accelerated vesting only if a founder is fired within a stated period after a change of control (“double-trigger” acceleration).

Restricted stock is normally used by startups organized as corporations. It can be done via “restricted units” in an LLC membership context but this is more unusual. The LLC is an excellent vehicle for many small company purposes, and also for startups in the right cases, but tends to be a clumsy vehicle for handling the rights of a founding team that wants to put strings on equity grants. It can be done in an LLC but only by injecting into them the very complexity that most people who flock to an LLC seek to avoid. If it is going to be complex anyway, it is normally best to use the corporate format.

Conclusion

All in all, restricted stock is a valuable tool for startups to use in setting up important founder incentives. Founders should use this tool wisely under the guidance of a good business lawyer.

When should I set up an entity for my startup business?

Startup Law 101 Series – When should I set up an entity for my startup business?

Introduction

Every founding team needs to decide when to set up a limited liability entity (corporation or LLC) for their startup. There is no hard-and-fast rule to follow but some basic guidelines will help you decide. Let’s see what they are.

Basic Guidelines

The guidelines are straight-forward, applying them less so. You should work with a good business lawyer to help with your individual case.

1. If you are a sole founder and have no business activities as yet, wait (but see #5 below).

2. If you have a co-founder or two, and are still in the garage stage, ask yourselves, “is what we have worth anything?” If you have any significant doubts, wait.

3. If you have something you believe is good (or may become so), and there are two or more of you, set up an entity. It will let you set your deal terms among yourselves. It will eliminate claims of the I-was-promised-a-big-part-of-the-company variety that can arise from ill-documented alliances. It will let you capture IP for the benefit of the company. It will help you avoid tax problems that may otherwise arise if you try to form the structure and issue equity at the same time you bring in funding. It will focus you on building your company profile. It will let you more easily talk up the company with other key people you hope to attract. It will give you a means of offering equity participation to a wider circle of people beyond the founder group. It will give you credibility in entering into contracts and alliances that will help you establish the business.

4. Whether alone or with others, if you are actively doing business that creates liability risks, set up an entity.

You need to use good sense here in deciding when the level of activity creates serious enough risks to warrant setting up an entity for this reason. This is an item to discuss with a good business lawyer.

You often hear about the wisdom of shielding your personal assets from business risks through limited-liability protection, and this is an important point.

Remember, though, that “limited liability” is mostly about disaster risks. If you have a good company and get sued, you will defend the suit and pay any normal judgment and it will cost you the same as if you didn’t have a limited-liability entity. There is no added “protection” here. Only if the disaster case happens (such as an overwhelming judgment) does the limited-liability entity help you by keeping your personal assets away from the flak. Limited liability also will not help you with the obligations you may need to personally guarantee, such as a lease for office space or equipment leases or a bank credit line. Nor will it help with obligations you might incur personally within a company context, as for example if a corporate officer aids and abets a company violation of securities laws (see a business lawyer about these types of risks). It does help with normal contractual dealings, with tort risks, and the like, but only where any given liability or an aggregate of them proves overwhelming for your company. If you merely encounter normal liabilities, you pay them with or without a limited-liability entity unless you are prepared to fold your company over a comparatively small matter.

If there is any doubt at all, though, set up the entity. Usually, if you have any extensive activities going with a lot of people, this would warrant having a structure. Why? Because, even when it looks safe to you, you might easily get blind-sided. For example, you pay your people as contractors and then find out in a disaster audit three years later that they are re-classified as employees and your company is stuck with huge added taxes and penalties. Out of the blue, you have an unanticipated disaster case. A limited-liability entity should shield you here. In such cases, better safe than sorry.

To sum up the limited-liability point: having a limited-liability entity is like having disaster insurance — it will cost you something but it will generally shield you against the big risks by keeping the damage localized to your company.

5. If you are attempting to raise funds, set up an entity as early as possible or you may bump into potentially serious tax risks at the time you issue stock to the founders. The rule of thumb here is that the earlier you do your founder equity grants, in relation to funding, the better.

Factors to Consider Relating to the Costs of Setting Up a Limited-Liability Entity

In every one of the above cases, costs need to be considered in relation to timing. It takes money to set up and maintain a limited-liability structure.

Here are some guidelines to factor in about costs:

1. Don’t be penny-wise and pound-foolish. If you have a situation that legitimately needs a proper structure, don’t delay just because of costs. The most noteworthy situation with a startup is where you have a founding team and a viable model. In such cases, delays in setting up the structure will likely cause problems. If cash is tight, see if your business lawyer will do a deferred-fee deal with you. If you wait, and problems do arise, the costs will be far greater.

2. Don’t assume that the LLC is a panacea for costs. A quickie LLC can sometimes be set up inexpensively using either a lawyer or an online service. With startups, this can potentially work well for a sole-member LLC (including husband-wife). For a founding team, though, where restricted stock is used, the LLC will be just as complex as a corporate setup and no cost savings will likely result from use of the LLC format.

Don’t forget either that an LLC is basically an old-style general partnership with a limited-liability cap on it. With multiple members, all the normal issues that need to be negotiated in a partnership still need to be negotiated and built into a properly drafted operating agreement. Who owns what? Who contributes what? Who manages what? Who gets paid what? Who gets to buy out whom and at what price? And many other issues. You can skip paying attention to this detail but you will invite all kinds of trouble in doing so. Thus, even if an LLC is the best vehicle for your startup, you won’t save much on setup costs if you do it right.

For startups with founding teams, a corporate set up is normally best. Check with a good startup business lawyer to make this assessment, but don’t let the tail wag the dog by choosing a less suitable vehicle simply to save on some initial costs.

3. With startups, use a seasoned startup business lawyer for any but ultra-simple setups that you can do yourself. This will save you costs because of the lawyer’s efficiency. Make sure to ask the right questions to confirm that your lawyer is indeed experienced with early-stage startups.

Conclusion

Founders often make the mistake of waiting too long to set up their limited-liability entity. Review the guidelines above, get your questions straight, and work with a knowledgeable business lawyer to make the right choice as to timing.

What every entrepreneur should know about business law.

Startup Law 101 Series – What every entrepreneur should know about business law?

Basic Guidelines

The Startup Law 101 Series is aimed at educating founders and entrepreneurs about the basics of startup business law. The question is – what should every entrepreneur know about business law?

Here are my suggestions on this important question.

1. Law is fundamentally a specialty field and entrepreneurs should leave it, for the most part, to the specialists when it comes to technical details.

This part can’t be emphasized enough. Law is a maze of complexities. If you, as an entrepreneur, try to master it at that level, you will be an unusual entrepreneur if you are not quickly discouraged into abandoning the effort altogether.

2. Entrepreneurs can feel trapped, though, by specialists who hem them in and sometimes abuse them. Lawyers have been known to attempt to capitalize on the “fear, uncertainty, and doubt” (FUD) factor that can be used to scare up business where none legitimately exists. So it can be unsafe to leave everything to the specialists without being informed about their proper role and without being proactive in managing their activities as your hired agents.

3. Entrepreneurs should attempt to gain a working knowledge of the law as it affects their companies. The emphasis here is on “working.” This is not a technical knowledge. This is not about going to law school or about learning to think like a lawyer. It is about trying to get the equivalent know-how about law that a serial entrepreneur might have – it is about knowing the decision points and the main factors that affect those decisions so that you can manage a lawyer’s efforts in giving you technical assistance on those points. It is about learning the fundamentals of how companies are formed, funded, managed, and sold. It is about understanding how deals work within a company context. As an entrepreneur, you don’t have to know how these things work beyond following the advice of your lawyers. But you will be far sharper if you do. You can be led by the professionals or you can actively manage their efforts, even while using their expertise, to help achieve your goals.

4. Therefore, though law is fundamentally boring for most entrepreneurs, the smart ones attempt to educate themselves in this area as needed to achieve the goal of being effectively proactive in working with lawyers and of being able to use the law effectively to further their business goals.

5. What does this investment of time and effort get you? It will educate you on how to use the law to help protect yourself from liability risks relating to your business. It will improve your ability to plan effectively for your company’s launch and growth. Finally, it will save you money because it will improve your ability to manage the time of your lawyers.

6. How do you gain this knowledge? That is up to you. I emphasize here only that you should not disdain the task just because it involves law. Nor should you overdo it in the other direction by diving into specialty forms of knowledge. Strike a balance. Invest the time needed to understand business law at a high level, with a strategic and not a technical focus. Use this author’s Startup Law 101 Series to learn the fundamentals of startup law. Read significant blogs in the area (the Startup Company Lawyer and The Startup Lawyer are good ones). Read the posts. Think about the issues. Get the larger perspective on how legal issues affect you and your company.

You can also use self-help resources from the publishers who specialize in such works. These can be helpful for learning about general legal issues affecting business, though they are less helpful for startup issues specifically.

In the end, experience will be your best teacher. But you will need to give yourself a foundational knowledge to ensure that you learn the most from your experiences. And, above all, make sure to work with a business lawyer who works with you and educates you about the legal steps you are taking. Do watch out for lawyers who keep you in the dark and who merely spread the FUD factor.

Remember, don’t be discouraged if you cannot understand legal technicalities. Your goal is not to master technicalities. It is to get a working knowledge. Place a high value on anything that gives you that perspective. This is what the serial entrepreneur has mastered. It is what you will need to master as well if you are to be optimally effective as an entrepreneur in managing legal matters to further your business goals.

Mistakes founders make – Ill-documented relationships.

Startup Law 101 Series – Mistakes Founders Make – Ill-Documented Relationships.

Introduction

Nothing creates more grief for an early-stage startup than an ill-documented relationship that goes wrong. Failing to document properly is by far the most common mistake founders make when setting up their companies.

The problem is a natural one. Things are loose and informal at the start, and no one knows for sure that the company will have value. It often makes no sense to founders to invest in lawyers to document things at that stage.

It is also true that many founders do just fine dealing informally with one another while awaiting the stage at which they feel it necessary to do formal documentation. In my experience working with founders since 1984, I would say that most situations do come out fine even though the founders assume legal risk when they fail to document. But those that don’t can and do lead to serious problems and so the issue is an important one.

So what is the answer?

Well, the obviously safe course is to hire a lawyer early, set up your entity, do your founder grants, put the IP into the company, document your service relationships with the company, and concentrate on building value into your properly documented startup.

If you choose to assume the legal risks associated with ill-documented relationships during the early stage, here are some guidelines for those of you who are doing your first startups.

1. Fair-weather friends abound. Be careful with any relationship until it has been tested. Those who are fair-weather often will not hesitate to make opportunistic claims if the circumstances favor them. Don’t get caught on the short end of such claims – a lawsuit is often lethal to an early-stage startup and it may cost you dearly to settle such claims.

2. Don’t let people do “favors” for your company unless you really trust them. Someone working in exchange for a straight payment has little or no basis for a legal claim as long as the payment is made. Someone working for little or nothing, though, can claim that the work was done in exchange for promised equity in the company. The claim may be bogus, but you are inviting it in such cases. If you do have such an arrangement, document what it is about in some kind of writing. If IP is involved, see a business lawyer and make sure the IP will belong to the company (you need a “work-for-hire” contract in this case).

3. If you see obvious signs of bad character, get everything in the arrangement formally documented as soon as practicable. Better yet, jettison such relationships whenever possible, the sooner the better. Even iron-clad documentation will not help much in such cases. It might sound trivial to say it but I have marveled at the number of times I have seen founders look the other way in hopes that a troublesome person will add enough value to offset the risks he brings to the company. Occasionally, this might prove true, but count the cost. Many a company has been dashed against this rock and ruined.

Your biggest risks in ill-documented relationships are (1) that someone will claim an equity interest in your company that you never intended to give, or will claim a much larger one than you intended to offer, and (2) that someone will claim rights in your company’s IP that you never intended to give.

The flip side of all of the above can happen as well. What if you are asked to do work for a startup in exchange for equity and you slave away at it only to get the jarring news later that no such promise was ever made. Without documentation, you are likely stuck. Yes, you can bring a legal claim but, for most people, this is a losing direction.

Again, the best advice is to go to a good business lawyer and get things documented properly early in the process. If you can’t do that for some reason, at least use less formal mechanisms to make clear what is intended by your arrangements. A simple, signed letter of intent stating your general goals, for example, and reciting that no promises have been made about equity (or the converse, if that is the case) will at least help curtail the most flagrant claims. If you can’t get others to sign off on a writing, at least try to document your intentions through email exchanges and the like – these offer only the thinnest of protection but are better than nothing at all. Don’t rely on verbal assurances only. You will come to regret this in that significant minority of cases where the ill-documented relationship does indeed come back to bite.

Conclusion

Founders often make the mistake of waiting too long to set up their limited-liability entity. Review the guidelines above, get your questions straight, and work with a knowledgeable business lawyer to make the right choice as to timing.

Mistakes founders make – Misunderstanding capitalization.

Startup Law 101 Series – Mistakes Founders Make – Misunderstanding Capitalization.

The Issue – What It Means to Own “X% of the Company”

What does it mean that you own x% of a company?

Founders can get confused on this issue. Why? Because there are at least three possible points of reference by which to measure percentage ownership. It can be measured with reference to: (1) issued and outstanding shares only (the narrowest corporate measure); or (2) issued and outstanding shares as adjusted to reflect the maximum dilution possible from the exercise of all stock options and other contingent equity interests outstanding in the company (the “fully diluted” measure); or (3) authorized shares used as a working model of where a company’s board of directors believes the shareholders will be at some future date (the working model measure).

In its own way, each of these measures can legitimately be used by founders in discussing percentage ownership in a corporation. Problems can and do arise, though, when founders discuss this issue and take actions on it without thinking about which reference point they are using. Below I describe the problems this creates and note what to look for to minimize potential problems on this important issue.

What the Concept of “Authorized Shares” Means

When an entity is formed it is capitalized. This means that founders contribute cash or other assets to the entity and, in return, get an ownership interest in the entity. In a corporation, this ownership is evidenced by shares of stock. In an LLC, it is evidenced by a membership interest or perhaps by units evidencing such membership interest. Whether you get shares of stock or some form of ownership units, you will own a certain percent of the company as a whole.

In various contexts, this question – “what percent of the company do I own?” – can be significant. Sometimes a key person is promised x% of the company in exchange for some specific contribution. At the time of funding, founders are told that they will give up x% of their company to VCs in exchange for the dollar investment being made. When they are considering such issues, founders need to understand how this terminology is being used in order to avoid misunderstandings and potential problems.

We could explain how this works with either a corporation or an LLC. Let us use a corporation to illustrate the points.

When a corporation is formed, the charter document (articles or certificate of incorporation) specifies the number of “authorized shares.”

The concept of “authorized shares” is an important one in corporate law. A corporation is a legal person. Being an artificial person, it acts through agents. There are shareholders, who own the corporation. There are directors, who sit as a board and manage it at the highest level. And there are officers, who conduct its day-to-day operations. Shareholders control the corporation by controlling the board, which in turn makes the most important decisions for the corporation. Having been put in place by the shareholders, the board is responsible for making all key decisions that are out of the ordinary course of the day-to-day business operations of the company. One of these decisions is whether to issue stock to various persons and on what terms and conditions to do so.

Got that.

The shareholders control the board.

The board determines what stock to issue and to whom and on what terms.

But the board must always act in the best interests of the corporation and its shareholders. Those who sit as directors on such a board have what the law calls a “fiduciary duty” to exercise the highest good faith and diligence to promote the interests of those shareholders.

To protect the shareholders, as the ultimate owners of the corporation, the corporate law sets an outer bound on what the board can do in issuing stock: the board can always vote to issue stock from the pool of shares authorized by the shareholders (or, initially, by the incorporator) for this purpose. It cannot exceed that bound. This rule protects the shareholders of a corporation from dilution of their ownership interest beyond the limits they have authorized.

So let’s recap again.

The shareholders control the board.

The board determines what stock to issue and to whom and on what terms.

In issuing shares, the board is ultimately limited in what it can issue by the number of shares previously authorized by the shareholders for this purpose — that is, the board’s authority to issue shares is ultimately capped by the number of authorized shares in the corporation.

This is important. The concept of “authorized” shares plays a vital role in corporate life by giving the shareholders an ultimate say on ownership issues in the corporation. But (and this is a big but), except when considered conceptually as the basis of a working model used for planning purposes only, the authorized-share concept has nothing whatever to do with what percentage of ownership interest any shareholder has at any given time.

Issued and Outstanding Shares as the Strict Corporate Measure

It is time for our first quiz.

You form a corporation and, as incorporator, designate 10 million as the number of authorized shares, all common stock.

You appoint yourself as the sole director and, acting as such, authorize 5 million shares to be issued to you as the sole shareholder. You pay for the shares and cause the corporation to issue them to you.

So, 10 million shares authorized and 5 million issued to you. What percent of the company do you own?

That’s right, you own 100%.

It is not, “I own 5 million of the 10 million authorized” and therefore 50% of the company. Remember, authorized shares have nothing to do with actual ownership at any given time in the corporation’s history. Only the issued shares count toward this purpose.

So, you own 5 million shares out of a total issued of 5 million and hence 100% of the company.

Let us extend the example. Say you have a co-founder who received 1 million shares at the same time as you got your 5 million.

What percent of the company do you own?

Now there are 6 million shares issued and outstanding. You own 5 million out of that total. Therefore, you own 5/6ths of the company, or approximately 83.3%. Your co-founder, in turn, owns 1 million out of the 6-million total, or 1/6th, or approximately 16.7%.

Again, none of this is calculated with reference to the 10 million shares authorized for this company. It is technically wrong, as a matter of corporate law, to say that you own 50% of the company in this example because you own 5 million out of the 10 million shares authorized, and it is equally wrong to say that your co-founder owns 10% in owning 1 million out of the 10 million authorized. Yet people will sometimes refer to the authorized shares as the basis for saying how much they or others own in a company and, when rightly considered, this has a certain logic to it. Let us consider, then, how this comes up.

A Potential Ambiguity from Using a Working Model as a Point of Reference

Let us now extend the example further and assume that you promise a key person who will be joining up with you and your co-founder that he will get 2% of your company if he does this or that.

In technical terms under corporate law, what is it that you have promised when you make such a statement? Well, there are 6 million shares issued, 5 to you and 1 to your co-founder. If you take 2% of the 10 million authorized shares, your key person would get 200,000 shares. But 200,000 in relation to the 6 million shares issued (plus 200,000 to be issued) is not a 2% ownership interest but rather about 3.2% (200,000/6,200,000). In technical terms, the 2% interest would be just over 120,000 shares (120,000/6,120,000 equals just under 2%).

While this is the technically accurate outcome, it is true that most parties, when discussing what “2% of the company” would mean in the above example, would likely think of the number 200,000. Why? Because they know that a corporation, or at least one functioning as an entity for a startup business, does not sit stagnant. It operates according to a working model.

In authorizing 10 million shares, you likely are working on the assumption that the 10 million shares will eventually be issued. You might even be thinking something like this: OK, 6 million shares to the founders, 2 million for an equity pool to be issued to key people, and 2 million for future investors. Hence, based on your working model, the correct way of interpreting “2% of the company” would be 200,000 shares, even though this would be wrong under strict rules of corporate law.

In a sense, both views are right. One measures the 2% with reference to existing shareholdings and the other with reference to anticipated shareholdings in the company.

It is precisely for this reason that founders get into trouble by making promises like “I will give you 2% of the company,” at least if they don’t clarify what they mean. Technically, under corporate law, this would mean just over 120,000 shares in our example. But if the recipient says he understood it as being measured with reference to the company’s working model, you have a problem and maybe even a lawsuit on your hands.

Issued and Outstanding Shares as Measured on a Fully-Diluted Basis

Let us shift to a different example to explain this further.

You have 10 million shares authorized, 4 million shares issued to founders, 2 million to investors who hold preferred stock convertible into common at a 1 to 1 ratio, and a total of 1 million stock options issued, none of which have yet been exercised. You are one of the founders and you own 1 million shares.

What percent of the company do you own?

Well, you clearly have 6 million shares issued and outstanding (4 to founders and 2 to investors). Does this mean you own 1 million out of the 6 total, or 1/6th, or just a shade under 16.7%. The answer is: yes and no.

Yes, in technical corporate terms. If your company were acquired in just that instant, and nothing in the acquisition made the options exercisable and none of the options were or could be exercised as of the closing date of the acquisition, you would share in exactly 1/6th of the total proceeds. If the company were acquired for $6 million cash, net of expenses, you would get exactly $1 million for your shares.

But no, not really. Because, while the above presents an accurate picture of what might happen in a particular instant of corporate time, the options in reality will likely become exercisable over the course of time and will or at least may be exercised in whole or in part. Indeed, the very point of issuing options is to provide incentives for key people. If they were not exercisable, that would defeat the point.

Therefore, you need to figure options (and all other contingent equity rights, such as warrants) into the equation to determine what percent of a company you really own. The technical term for taking all these into account is to say that you own “x% of a company on a fully-diluted basis.”

If we look at our example using the “fully-diluted basis” measure, then, you would own 1 million out of a total of 7 million shares either issued and outstanding or issued contingently and capable of being converted into shares in the future. Thus, you would own 1/7th of the company, or just a shade under 14.3%.

Does this mean that you might not actually get a higher percentage should an acquisition occur before all those options and other contingent interests were all exercised? Almost undeniably, you would get some higher percentage interest in most real-world situations.

Why? Because options typically require vesting and not all holders of options will vest in full. Thus, some options will simply be lost to their holders and would hence be subtracted from future computations of the “fully-diluted” capitalization of the company. Still other options will not have acceleration provisions attached to them and will not be vested (and hence not exercisable) at the time of any acquisition.

While the exact outcome is in flux, this arises from the nature of the equity interests in a dynamic startup and not from the measure itself. The fully-diluted measure is in fact the most accurate way of assessing the percent of a company that one has at any given time.

Let us again recap regarding the available measures for measuring percentage ownership in a company. In our first example above, we identified two reference points that might create ambiguity in how a shareholder might understand his percentage of company ownership: his holdings might be measured with reference to issued and outstanding shares only or it might be measured with reference to the company’s working model. To this we must now add yet a third one (the fully-diluted measure): shares can be measured with reference to the total of all shares, option rights, and other contingent rights outstanding in a company by assuming that all such contingent rights have been converted into shares.

How Capitalization Is Measured in VC Funding Deals and the Potential for Confusion by Founders

Now let go one step further to see how VCs measure capitalization at the time they make their investments.

VCs will typically take preferred stock but the nature of the stock they receive is not relevant to our illustration if we assume that their preferred stock will ultimately be convertible 1 for 1 into common stock (which we will assume here).

Let us go back to our example with 10 million authorized shares. You are a founding team holding 4 million shares total, which you issued to yourselves at trivial pricing at the time of company formation. Now you negotiate with the VCs a $6 million “pre-money” valuation for your company. They are prepared to invest $4 million in a Series A round. When added to the pre-money valuation, this gives the company a value “post-money” of $10 million. The VCs will pay $1 per share for their stock based on these valuations. They get 4 million shares for their $4 million.

In this example, the founders have 4 million shares, the VCs have 4 million shares, and the remaining 2 million shares out of the authorized total are designated as being set aside for an equity pool of shares to be issued to key people as incentives.

Now, it is the near-universal rule among startups to treat this scenario as one in which the founders “get 40% of the company,” the VCs “get 40% of the company,” and the remaining 20% is reserved for equity incentives.

This type of assessment is accurate if we assume that such percentage computations are calculated with reference to the working model negotiated between the founders and the VCs for this investment.

And there is, of course, nothing wrong with such an assessment. It is exactly what the parties have in mind when they make such a deal. Indeed, every such deal is accompanied by a sophisticated “cap table” that spells out the company capitalization in intricate detail, factoring everything possible that might contribute to the ultimate dilution of the total shares.

Yet great confusion typically results from this method of figuring and discussing capitalization.

Why? Because, in reality, under corporate law, the founding team that just did this deal has given up 50% of its company, not the 40% discussed with the VCs under the working model.

When control issues are discussed, you have in this case a classic case of shared control because each group holds an identical interest, just as in any 50-50 situation.

If, by some miracle, the company were to be acquired the day after the Series A closing in this example, the VCs would get 50% of the net proceeds of the sale, not 40%.

If part of the negotiated terms included giving the VCs the right to designate an outside CEO who would get a large grant of stock as part of his compensation, the control would shift immediately and decisively to the VC side. They would not need a full 10% shift, as might be implied from the idea that they hold a 40% interest. They would need only the slightest shift to hold just a bit more than 50% and thereby gain control.

I do not raise these issues to imply perfidy on the part of VCs. The deals so structured are legitimate ones. The parties know what they are doing and specifically negotiate them in just such a fashion, each to attempt to achieve its goals. And those goals are by no means seen as adversarial at their core. All parties see the structure as one by which they can work together to their mutual benefit. The investors have as much right to protect their investment as founders do to protect their position. In reality, each side works cooperatively with the other while taking formal steps to protect itself from potential abuse. This makes sense and is a healthy outcome for all concerned. Issues such as control are often negotiated in great detail and there are often agreed-upon terms specifying who will get what board seats and the like.

What I do mean to say here, though, is that founders need to understand the full implications of what they are doing when they do such deals. In the example just cited, they are not giving up 40% of their company but 50%. Yes, if it all plays out and the equity pool is ultimately exhausted, it will turn out to be 40%, as each of the 50-50 players will be progressively diluted to 40% as the pool shares are issued and converted into stock.

As a founder, by all means, do such deals when they meet your interests and those of your company. Just understand their implications. Should you encounter an unscrupulous VC firm under such an arrangement, you may find yourself out in the cold long before the equity pool is exhausted and your founding team’s theoretical interest diluted to 40%. Once control is lost, moreover, any shares you own that are subject to vesting would likely be forfeited if a coup occurred and your service relationship with the company arbitrarily terminated.

Do the deals, then, but understand the risks. A good VC firm will add value far beyond its money investment. A bad one can cause problems far beyond the dollar impact of its investment. When you make assumptions about who owns what percent of a company, and who can do what as a result of that ownership, you need to know which shares count and which are only part of a working model that do not count toward ownership under corporate law as measured on the day the VC round closes.

Conclusion

We have reviewed various scenarios of what it means to “own x% of the company.” As you have seen, the phrase can mean different things to different people, depending on whether it is being measured by actual shares issued, by such shares when “fully diluted,” or by a working model that makes assumptions about what shares will be issued in the future. All are legitimate modes of measurement, depending on the situation. Just make sure you understand which is being used when you assess your own interest and the interests being granted by your company to key people and to investors. If you fail to do so, you may get into trouble.

Of course, don’t forget to check with a good business lawyer on all such issues. The decisions will always be yours but you should make them with open eyes. A good attorney will help immeasurably on such issues. Don’t neglect this resource.

Mistakes founders make – Misusing form contracts.

Startup Law 101 Series – Mistakes Founders Make – Misusing Form Contracts

Introduction

Ours is an era in which legal forms proliferate and many entrepreneurs are tempted to use them without much thought given to customizing them for the specifics of their deal.

This is a mistake.

The unthinking use of legal templates assumes that the law is a mechanical process, as capable of simplification as is the process of selling widgets. The thinking goes something like this: You find a widget on the web. You buy it for a cheap price. You use it. Hence, no need for those middlemen lawyers who charge a lot for pulling the identical widget out of their drawer and handing it to you with their bill.

There are some partial truths here. Some contract situations are utterly routine. And lawyers sometimes have abused entrepreneurs by keeping them in the dark while running up billings in simple situations. It does not follow, however, that contracts are merely widget-like and interchangeable units that anybody can use in plug-and-play fashion.

In reality, the law is a slippery beast, one that normally defies simplification. David Dudley Field made a famous effort to simplify California’s laws in the 1870s. The most educated men of that era consciously set about to take all of California’s laws and make them so simple that even the least educated person could understand them. The result – a world-class belly flop. The judges took the simplified new layer of laws embodied in the Field Codes, wove them into a complex system of legal interpretation, and – voila! – California emerged with the most complex set of laws in the nation.

Why does this happen? Why does law so stubbornly defy being reduced to a system of unthinking application that is easy to understand and administer?

Because, like it or not, law is designed to regulate human affairs that are themselves complex. And it cannot do this effectively unless it is customized to the situations at hand. This is why judges decide issues case by case. It is why law has so many localized variations. It is why a canned contract, beautifully drafted though it may be, will ill serve the parties who adopt it without thinking through its implications.

Again, like it or not, business and corporate law is complicated. So too is intellectual property law. And tax law. And securities law. And licensing law. And distribution law. And property law. And all other forms of contract and commercial law. Have you ever tried to deal with an unsecured debenture? Or a reversionary interest? Or with any other of thousands of bizarre-sounding legal concepts that seem to float in and about the law that surrounds businesses and corporations? Yes, you may be familiar, from your practical experience, with what FOB means as a commercial shipping term. Or with what an “implied warranty of merchantability” means. But take such terms, multiply them by the thousands, put them in an unfamiliar context, and what do you get? You get a web of legal terms of art, each of which has a specific meaning only when understood within a complex legal context.

This is much more than the case of a lawyer trying to spread so-called “fear, uncertainty, and doubt” in an illegitimate manner. This is the reality of law trying to comprehend and regulate complex affairs that do not lend themselves to simplification when considered as a whole.

Therefore, contract and commercial law is highly complicated and does not lend itself to thoughtless application. If it were only a matter of filling in the names, for example, on a partnership agreement, then anyone starting a business could go to a stationery store (the old way) or go to a forms download site (the new), buy a canned partnership agreement, fill in the names, and be done with it. This is normally an unwise way to form a company. Such a boilerplate form may have nothing to do with the nature of the business being set up by the parties. It may have language in it that has no bearing on their deal and that will only confuse them and everyone else concerning what was intended by their deal. Worse, it will not expressly set forth the nature of their deal to make clear what they intend in their contract. Such a contract is an open invitation to litigation should anything go wrong in the deal between such parties. Perhaps tens or even hundreds of thousands of dollars will be spent hashing and re-hashing ad nauseam what they intended when they “agreed” to badly-worded boilerplate. If you have ever had the misfortune to suffer this fate, you will never again resort to such corner-cutting in documenting the affairs of your startup business or small business.

All but the simplest of contracts need to be reviewed carefully by someone with a discerning eye and also need to be understood in their full legal context. A contract review, of course, can be done by a smart lay person using self-help resources. And some people are inclined to invest time and effort for that purpose in a way that helps them manage their legal budgets more carefully because they pick up a lot of the burden themselves. But it is a burden, and it has a cost attached to it – there is always a cost-benefit component to any such effort. What is worse, many people do not do a good job of thinking through the issues and wind up cutting corners. A contract in their hands can be like a loaded gun in the hands of a six-year old – wildly unpredictable and sometimes dangerous results can follow.

Moreover, context is critical. What seems placid on the surface can hide legal turbulance beneath. Sell stock to investors with a simple purchase agreement. Fine. I sell. You buy. Then, later, you find you did not comply with securities laws. Or that your buyer gets a large taxable gain for having contributed intangible assets for his stock. Or that your deal violated someone else’s rights in the company that restricted such sales. Yes, lawyers can and do sometimes spin such issues out needlessly. But such issues can and do exist in many cases. When you use a boilerplate form, you need to see beyond its apparently simple boundaries to understand how it functions legally in its broader context. Otherwise, you might step into trouble without having the slightest idea that you are doing so.

So, can you as an entrepreneur use boilerplate forms with impunity without fully understanding them and without understanding their context? In some cases, yes. You need a simple promissory note, and the generic one fits your needs without too many risks of getting legally blind-sided in a simple transaction. You need a canned nda for your employees and you have a form you had used in a prior company – the type of form that has remained pretty constant over many years of use. This can work for you and, even when there are potential technical problems with the documents you are using, the problems may never arise in your particular situation.

For every case where entrepreneurs either can or do get away with it, though, there are all too many situations in which their attempts to do so proves ill-advised. Flying blind does have its limits, after all.

Bad business lawyers are lawyers that simply take forms and switch the names without giving thought to the nature of the deal before them. Bad as this may be, at least such lawyers have a modicum of legal education and experience to be able to spot some of the legal issues and some of the potential traps.

The same cannot be said for an entrepreneur trying to do the same thing but without the benefit of a legal education or legal training. This then is the worst of all cases. Don’t put yourself in this situation.

The issue gets confused when the entrepreneur will have had significant exposure to certain types of legal documentation, as for example in the case of one who managed the contracts of a large company in an executive capacity while working under the guidance of skilled lawyers. In such cases, someone who has had a lot of practical experience with a particular class of contracts is often far more aware of their ins and outs than are non-specialist lawyers who have not dealt much with such contracts.

This is true as well of the seasoned entrepreneur who has developed such a strong working knowledge of business deals as to be able to run rings around certainly any green business lawyer who attempts to work on such deals.

While all this is true, it simply means that law has a practical side as well as a theoretical one, and any smart person who has worked through complex legal deals often enough will come away from that experience with some excellent skills applicable to such deals. Serial entrepreneurs, contract managers, and others with like experience fit this mold.

This only confirms, however, why it is ill-advised for an entrepreneur to try to do business by using legal forms unthinkingly. The seasoned entrepreneur, the skilled contract manager, etc. may not be business lawyers but do have the vast experience to be able to think their way carefully through a complex contract. Even then, such persons will attest that they ultimately need their deals reviewed by a skilled business attorney. Though they may be able to drive a deal more efficiently owing to their experience, they themselves know this is no substitute for using the services of a lawyer who is an expert in their field.

The operative word is “think.” A good business lawyer will think carefully about any given deal and will customize any contract for the commercial situation at hand. A seasoned entrepreneur will do the same within the limits of a layman’s knowledge in a technical field. An entrepreneur using good legal self-help resources will similarly think through the issues carefully within the limits that such resources enable.

It is the unthinking use of boilerplate forms that does not cut it. Use of boilerplate forms without the requisite training, experience, and education does not give an entrepreneur any basis for thinking through a deal to spot the issues and potential trouble spots. Don’t use boilerplate forms mindlessly. In the end, it may cost you dearly.

Mistakes founders make – Neglecting securities laws.

Startup Law 101 Series – Mistakes Founders Make – Misusing Form Contracts

Securities laws are not to be trifled with. Among other things, if you violate them, your investors can ask for their money back from your company and from those who control the company.

Yet founders are sometimes careless in complying with securities laws.

Here are some very high-level guidelines for complying:

1. The broad rule is this: either you register the shares to be offered or you find an exemption from registration for the type of offering your company will make. It has to be one or the other.

Registration at the federal level is a public offering. No early-stage startup does that.

At the state level, registration is still a formal and expensive process. Few early-stage startups do that either.

Therefore, the key securities law concern for any stock issuance by an early-stage startup is to make sure that the offering fits within an exemption to the registration requirements.

2. You must not only find an exemption under which you can make the offering, but you must find an exemption that applies to each purchase and sale of the stock that is made under the offering.

You will need a federal (SEC) exemption. The easy one is the intra-state offering exemption, which applies where all purchasers in the offering reside in your company’s home state. Beyond that, the question is fundamentally whether your offering is a private placement under either Section 4(2) or under Regulation D, the former of which is subject to murky legal standards and the latter of which defines “safe harbors” that essentially take away the murkiness. Finally, Rule 701 exempts qualified issuances under employee incentive plans.

You will also need a state exemption for each state in which any of your purchasers resides. The securities laws of each of the respective 50 states are known as “blue sky” laws. Whenever your company sells stock, you need to do “blue sky compliance” for each state involved in the offering.

3. Federal and state securities law exemptions are tricky and complex. Use a good business lawyer to guide you through the process. With skilled guidance, the process is neither too involved nor too expensive for most early-stage offerings.

So where do founders go wrong in this area?

Founders will sometimes use counsel for an initial offering and will complete that offering with proper securities law compliance owing to counsel’s guidance. So far so good.

Where founders get into trouble is where they thereafter assume they have learned the blueprint for an offering and do the next one themselves, without attorney help and without bothering with securities law compliance. Focusing solely on the buy-sell aspect of the stock sales, they forget the accompanying details that make those sales legal in the first place. This will normally not happen when they inform counsel of their plans. It happens when they don’t bother with that step.

Another way that founders get into trouble is by getting ensnared by the doctrine of “integration.”

Most states have some variation on what California calls a limited-offering exemption, which is basically an offering and sale of stock to a limited number of people who have a pre-existing relationship with the company or its founders. As long as the offering is limited to the number of purchasers authorized by the exemption, there normally is no problem.

Problems arise when founders complete their offering and then later have second and third offerings of a similar type within comparatively short time periods. This is what I call the rolling-offering problem.

Under securities laws, such offerings can be “integrated” with one another, i.e., treated as if they were not separate offerings but rather one continuous offering. If they are so integrated, then a sale of stock to 25 persons in one offering can be combined with another sale to 15 other persons, with the result being that the company is deemed to have sold stock to 40 persons in a single offering. If the applicable exemption says that, in order to be exempt, the offering must be limited to 35 persons, then integration will blow the exemption.

The common problem in both these examples is that founders assume they don’t need to consult with their business attorney once they think they know the “blueprint” for a stock offering. They then run wild and unsupervised in making their stock sales. And they get themselves into trouble.

What are the penalties?

The main one is rescission. If stock is sold that is neither properly registered nor exempt, then each purchaser can rescind the sale and get his money back either from the issuer or from those who control the issuer. A very dangerous and potentially expensive remedy for founders who play too loosely with securities laws. This is not just corporate liability. It is personal liability.

The rescission remedy can also be problematic if stock issued initially to founders or other key people is issued in violation of securities laws. Of course, no one cares if such early-stage purchasers rescind and ask that their trivial cash purchase price be returned. But what if the purchase price included assignments of IP into the company? Rescission enables such purchasers to rescind and to demand that all items of value transferred into the company be returned to them. Again, a very dangerous and potentially expensive problem for your startup if it results in a cloud hanging over the company’s key IP.

How to prevent these problems?

Three key things to keep in mind: (1) remember that no equity can be issued without securities law compliance, ever – don’t ever treat stock, stock options, warrants, etc. as if they were items of candy that you can simply hand out to any willing recipient; (2) do use competent securities law counsel to assist with your stock offerings, whether to founders, bridge or seed investors, angel investors, or VC investors; and (3) whenever possible, limit your stock sales to “accredited” investors. Accredited investors can be individuals or entities and there are detailed rules defining who they are. In general, for individuals, it is either high-income individuals or those having a net worth of at least $1 million. See your business attorney for details.

Why is it important to deal with accredited investors only, if at all possible? Because they normally don’t count toward the number of purchasers to whom you may sell stock in qualifying for most exemptions. Thus, in our example above of the rolling offering, you would not have a problem with the offerings being integrated if your investors were all accredited. In such a case, you would not exceed the numerical limit because the accredited investors wouldn’t count toward that number.

In addition, with accredited investors, you will normally have a much easier time generally complying with disclosure and other requirements that are part of the exemption process than you will have in dealing with less sophisticated investors.

Don’t trifle with securities laws. Work closely with a good business lawyer to ensure compliance. If you don’t, it will likely cost you far more to untangle problems than any money you might have saved in trying to skimp on the lawyer costs. Don’t be penny-wise and pound-foolish in this important area.

Tips from a business lawyer on becoming a founder.

Startup Law 101 Series – Tips from a Business Lawyer on Becoming a Founder.

Introduction

Why become a founder? What are some things you can do to become a successful founder?

Having worked extensively with founders as a startup business lawyer in Silicon Valley for many years now, and having built my own business as well, I have a few tips to share on these points.

Tips on Why You Should Become a Founder

Why become a founder?

1. If you succeed as a founder, you will make far more than you would as an employee. Obvious, but worth repeating.

Founders want the large upside that will come from a successful venture. The goal is very hard to achieve but the rewards can be great.

2. If you succeed as a founder, you keep more of what you earn.

As an employee, you will get hit with ever-increasing taxes on your compensation.

Forget about the rich. It is the average employee who gets soaked. You pay, say, up to a third of what you earn for federal, state, and local income taxes. Add another nearly 10% for payroll taxes. Now assume that inflation bumps you into higher tax brackets. Rates are then raised for those brackets. Then payroll tax rates go up. And the social security cap lifted. And new taxes added to fund future health benefits. You will be left with an ever-diminishing net amount from your pay. Welcome to being the employee of the future.

As a founder, however, your largest reward by far will come not from salary but from a liquidity event at which you cash in your chips. At that point, you pay a one-time capital gains tax for the vast part of the economic reward you derive from your venture. You pay less income tax because the capital-gains rate is lower. And you pay no employment taxes at all. With capital gains, you also control timing somewhat and this can further help minimize what you pay.

It all comes from the same effort. You sweat for what you earn. You can take your reward as ordinary income or, as a founder, convert a big part of it into far more advantageous equity gains. With success, you not only earn more but you keep more as well.

3. Being a founder can be not only financially but also psychologically rewarding.

When you venture out, you get the chance to realize a vision for your company and to benefit not only yourself but also your co-founders, your investors, your employees, your customers and the public generally. You get to watch your enterprise grow and prosper. You get to watch it have an impact on others for good.

The satisfaction you can derive from success is a great intangible reward.

4. Finally, being a founder gives you the independence of being your own boss. You will rise or fall by your own merits. This is a great opportunity and a great challenge. This is the one advantage that most entrepreneurs will ultimately say they value most.

Tips for Becoming a Successful Founder

What does it take to be successful as a founder? Here are a few thoughts.

1. Above all else, build from strength.

Be prepared before you venture out. Get a strong education. Work with the best to get excellent training in your field. Master your craft. Build relationships. Take what you do best and improve upon it. That is the key to innovation. And this is the best path for most founders.

Or you might build on the strength of exceptional entrepreneurial talent alone. Or a specialized skill that lets you team with others who supply what you might lack. Nothing formulaic here. But you do need to build on some form of strength.

This also means that you do not venture out based on a bare idea. Try this one from the bubble era: “I have worked one year in manufacturing and know how to revolutionize that field through an idea I have for a website.” Sorry, but abstract ideas get you nowhere.

It also means you do not do something just because you are tired of something else. Think twice about that romantic little tea shop. That is, unless you know about the business of tea shops. Others do, and they will make you pay. Know what you are doing before you step into something.

No one will carry you when you go out on your own. Therefore, be ready to build on something you do exceptionally well. That is your primary key to success as a founder.

2. Count the cost before you venture out.

You need the right temperament to go into business for yourself. If you crave security and certainty, being a founder is not for you.

Don’t romanticize the process either. Business is tough. You will lose the certainty of a regular paycheck. You will have bills to pay, whether or not you are making money. You will face a non-stop array of challenges, everything from people issues to financial pressures to competitor challenges to legal disputes to huge psychological pressures to all manner of other obstacles. When you get past all of this, or at least most it, you will have built “good will” – that is, a going concern value for your venture. Good will is really nothing more than the advantages you gain from the blood you have spilled. It is a huge plus that makes your business better than others. But you will have to spill blood over it. Understand this up front and be prepared to pay the necessary costs.

It follows, of course, that if you are not ready to pay the costs you should stick with the steady job.

3. When you launch, try to do so with a multi-talented team.

There is no fixed rule here. Experience confirms, though, that a team will be far more likely to succeed than will a sole founder. This may be just another way of saying that, if something is truly good, others will be drawn to it. More likely, it is another way of saying that launching and building a successful venture is hard to do and you need a multi-talented team to make it happen. Where you cannot supply everything, others will supply what you lack.

4. Make sure you have a sound business model.

Technical innovations are great but, in themselves, cannot normally sustain a venture. Sometimes, they can be sold or licensed to a large company. Nothing wrong with that. In most cases, though, technology will not be enough.

With or without key technology, if a venture is to be successful, it must have a sound business model that allows it to build and sustain a meaningful competitive advantage that makes it consistently profitable.

Without that, you will go nowhere, no matter how innovative this or that element of your venture may be.

5. Watch your expenses.

Wasteful spending is perhaps the single biggest fault of early-stage companies.

Small business entrepreneurs have far less difficulty with this than do startup founders. Why? Because they usually are dealing with their own money. If you know what it took to earn it in the first place, the odds of your being profligate with it are greatly reduced.

One aspect of wasteful spending is simply extravagance. You get funded and you go out and get the best that money can buy. Expensive offices. Extravagant salaries. Lavish parties. And on and on. In early-stage companies, you will regret such spending when you hit the bumps in the road where you wish you had that cash. Inevitably, you will hit such bumps. Plan accordingly.

Another side to wasteful spending, though, comes from not focusing your efforts properly in the early stages. You have ten great things you want to do as a company. You don’t make good judgments about which of these to focus on. You spend on all of them. In short order, your funds are dissipated before you can build a reasonable revenue stream.

Use good judgment about where you can best use your limited funds and use them wisely.

6. Plan your legal roll-out carefully.

Don’t front-load unnecessary legal expenses. When you are ready for a meaningful launch, though, do your setup properly.

If you have a founding team, make sure you give serious thought to using restricted stock as opposed to outright stock grants when making grants to founders. In other words, keep strings on the stock until it is earned unless there is some exceptional reason not to. Use cheap stock to avoid tax problems. Get the IP into the company. Get employment and consulting agreements in place, making sure all IP from such arrangements goes to the company. Review your trademark issues in connection with any branding you will do. File provisional patents as applicable. When you are ready to bring on a broader team, set up an equity incentive plan.

Work closely with a good business lawyer to do the legal steps right.

7. Fund your company incrementally where possible.

The worst trap an early-stage company can fall into is one where it gets over-extended. Plan intelligently to avoid this trap.

Work with early-stage investors or have a reserve of your own funds to carry you through the phases before you have meaningful revenues.

Don’t put yourself in a position where you are out of options except for shopping your opportunity to VCs. You will either not get funded (the most likely outcome) or you will get slaughtered in the terms of the funding.

Conclusion

Think carefully before venturing forth as a founder. The rewards can be great but you need to be ready to deal with the challenges. If you believe you are, a big, open world of opportunity awaits you.

Why founders should use cheap stock in capitalizing their startups.

Startup Law 101 Series – Why Founders Should Use Cheap Stock in Capitalizing Their Startups.

Founders will normally want to use so-called cheap stock when they capitalize their startups.

When you form a startup, you contribute cash or other assets to it in exchange for stock. You can also loan money to the entity. The ratio of debt to equity should be modest – normally not more than 3 to 1 (check with your business lawyer or CPA). While capitalizing with debt is common for small corporations, it is less so for startups, where straight equity capitalization is the norm. That capitalization normally involves cheap stock.

Why use cheap stock?

Cheap stock is important because founders will often earn their equity over time as they perform services for the company. The IRS may treat the value of that stock as taxable compensation. If you want to minimize tax, keep the value of the stock low.

The idea is to value your IP as low as possible and to assign it to the company along with modest cash contributions while pricing the shares themselves at a nominal price. If a company has modestly valued IP and nominal cash, it is not worth much and neither is its stock.

Founders may chafe at the idea of placing a low value on their IP. Not to worry. At the time of funding, investors will see this strictly as a positioning move.

A common model for startups is therefore to authorize millions of shares of low-priced common stock, with some percentage allocated to founders, some reserved for an equity-incentive pool, and some reserved for future investors. For example, 10 million shares might be authorized, of which 4 million could be issued to founders, 2 million reserved for an incentive pool, and 4 million reserved for investors. In this example, the founders might price the stock at a tenth of a penny ($.001) per share and thus contribute a total of $4,000 for the 4 million shares issued to them.

Large share numbers can give startups a psychological edge in recruiting. The more shares, the larger the option grants. Which would you rather get, 1,000 or 100,000 options? Each might represent an identical interest in a company but the psychological question answers itself on which sounds better. Startups set up their structures accordingly.

How does a cheap-stock strategy play out when it comes time for funding? In our example above, let’s say that our startup with 10 million authorized shares does a Series A preferred stock round at its first funding. Assume that this startup amends its articles to authorize 4 million shares of preferred stock and that it raises $4 million, with (1) the investors getting 4 million shares of preferred stock at $1.00 per share (convertible one-for-one into the 4 million shares of common reserved for investors); (2) the founders continuing to hold their original 4 million shares purchased at $.001 per share; and (3) the remaining 2 million shares either issued or reserved under an equity incentive plan for key service contributors.

The startup now has a post-money valuation of $10 million (10 million shares times $1.00 per share). Factoring in the dilution that will result once all 10 million shares are issued, the founders now own 4 million out of 10 million shares, or 40% of the company. If the company as a whole is valued at $10 million, that 40% interest has a paper value of $4 million. The founders paid only $4,000 to acquire that interest, say, 12 months earlier. Yet if all other formation issues were handled properly (including the filing of timely 83(b) elections), the founders will not normally risk incurring tax liabilities from the paper gain they have already realized.

Was their interest worth $4 million at the time of company formation? Who knows? At that stage, all numbers are nebulous. This is generally safe territory for using low valuations.

What do founders accomplish by using cheap stock? If the startup fails, they lose nothing more than the value of their labor. If it succeeds, they can ride through its ups and downs on the strength of capital investments made by others via outside funding. They pay no tax along the way. Any gain realized from the ultimate sale of their stock will be taxable only when they get tangible value in return and then most likely at favorable long term capital gain rates.

Thus, cheap stock lets founders position themselves optimally from a tax and economic perspective to benefit from any ultimate success they may have.

Cheap stock also benefits other key people besides founders. Options may not be issued at founder pricing but normally are issued at a significant discount from what investors ultimately pay. As long as the startup is careful to avoid steps that cause a large upward valuation on the stock price during the early stages, the discount model can be maintained and significant equity incentives offered to key service contributors who come in after the founders.

As a startup matures, the use of cheap stock is normally neither feasible nor desirable. At that time, its use may be unfair to existing shareholders and may also run afoul of a special Internal Revenue Code provision (409A) that imposes penalties if stock used for deferred compensation is not valued correctly.

In the early stages, though, the cardinal rule is to use cheap stock. It pays dividends for all concerned. Don’t neglect this fundamental aspect of setting up your startup.

One caveat: a corporation that is under-capitalized for the business it conducts can be at risk for having its “corporate veil” pierced. Work with your business lawyer to ensure that you do your startup capitalization properly.

Key legal rules for who owns the IP relating to your startup (work-for-hire).

Startup Law 101 Series – Key Legal Rules for Who Owns IP Relating to Your Startup.

As a founder, you need to understand work-for-hire. Why? Because it determines who owns key IP in your startup.

Copyright laws protect creative works, including IP that you develop. When you develop IP for others, the work-for-hire idea affects who owns it.

How does it work?

Here are some guidelines:

1. You develop IP for your startup as its employee “hired to invent” – the IP belongs to your employer. Pretty basic. This is a classic work for hire.

There are gray areas but, if you create IP while doing employment duties for which you are paid, there is no ambiguity. All IP relating to such work automatically belongs to your employer, whether or not you signed any agreement relating to it.

2. You develop IP for your startup as a consultant and are paid for that work, but have no agreement in place relating to the IP rights – it might surprise you to learn that the IP here would belong to you and not to your startup.

Why? Because the default rule under copyright is that the creator of a work owns the copyright unless (a) it is done as a work for hire or (b) it is expressly assigned under a contract to the other party.

Contractor work is a work for hire only if there is a contract identifying it as such and, in addition, the work falls within certain specified categories of types of work that qualify as works made for hire.

No contract, no work for hire.

No contract, no assignment.

Thus, with no contract specifying that it is a work for hire and with no assignment, the default rule kicks in to provide that you own the copyright to the IP you created even if you were paid for your work.

3. You develop IP for your startup as a contractor and are paid and have a work-for-hire agreement that contains no express assignment provisions in it – again, perhaps surprisingly, you still would own that IP if it involved a software development effort.

Why? Because software development does not fall within the specified categories that would allow it to qualify as a work made for hire in the contractor situation.

Thus, to ensure that IP rights to software are transferred from the contractor to the startup, you will routinely find language in work-for-hire agreements that says, in effect, “this is a work made for hire but, just in case it isn’t, the contractor agrees to assign all IP rights anyway.”

4. Which brings us logically to our last case, that of the contractor who develops IP for a startup, gets paid, and does the work under a work-for-hire agreement that characterizes the work as one made for hire and that assigns all IP rights to the startup – in that case, the startup owns the IP rights free and clear and you retain no rights to the IP.

How might these guidelines play out in practice for you as a founder?

We can assume that you would want your startup to own all its IP. What are potential problem situations by which the startup could face claims from founders or others that parts of the company IP belong to them separately, with at best only a license to use it extending to the company?

Let’s look at some cases to see how the guidelines might apply when we strictly consider work-for-hire (for your specific case, see a good business lawyer).

You and your buddies are developing IP for a startup you hope to launch. There is no entity. Ergo, there is no employment relationship and there is no contract between you and any entity (nor, typically, between you and any other person) relating to your development work.

Quick quiz: who owns the IP rights to your work under work-for-hire principles?

Answer: you do.

No employment. No work-for-hire agreement. No assignment. Hence, the default rule applies and the person who created the work keeps all rights to it.

Let’s assume your buddies paid you for your work in the case just cited.

Who owns the IP now under work-for-hire principles?

You would still own it.

The mere fact of payment changes nothing. For the rights to transfer, you need a work made for hire or an IP assignment. Without an agreement providing for either of these, the ownership rights stay put with you as the developer – even if you got paid.

Now let’s take the same case and assume you are a developer working offshore, say in India. You have a software development agreement with a startup in the U.S. specifying that it is governed by U.S. law. That agreement has a statement of work, defines deliverables, a development timetable, and a price. You comply with all this and deliver the work to the startup. The agreement is silent on all other points.

Now who owns the IP under work-for-hire principles?

Yes, that’s right, you, the offshore developer, own it. Payment or no payment, if it is not done as a work for hire, and if the IP rights are not expressly assigned, the startup gets only an implied use license and not ownership of the IP.

Let’s shift a little.

You and your co-founders form your startup. You assign all IP rights into the company. Then, in the spirit of keeping things loose, you continue to work on the IP development after company formation without contracts of any kind and without setting up an employment relationship between the company and its co-founders.

Who owns the IP rights to the post-formation development work?

Yes, the founders do, individually that is. So if one of you bolts, the company may have a problem with its IP or may need to do a workaround.

Why so? No employment relationship. No work-for-hire agreement. No assignment. Default rule kicks in and the rest follows.

Let’s look at one last case, the one where your startup does a work-for-hire development project for a customer.

Your startup has core IP that it uses in all its consulting projects. It contracts with Big Company X to do some custom development work. It signs the customer’s standard form. That form says, “this is a work made for hire and, by the way, if it isn’t, you agree to assign all IP rights relating to the deliverables to the customer.”

Anything wrong with that?

Yes, there is plenty wrong, at least if you don’t want to compromise your startup’s rights to its core IP.

In such cases, the boilerplate language (which seeks to assign to the customer who is paying for it any IP that does not otherwise qualify as a work-for-hire) may have an unintended consequence: it potentially sweeps in, along with what is intended by the parties, the core IP that your startup uses for all its projects.

Oops.

As a founder, you need to be alert to the effect of such language. A simple carve-out solves the problem, assuming you catch it up front.

That wraps up our quick tour of some key legal rules for understanding who owns the IP relating to your startup. There are some obvious lessons here: if you as a founding team are drifting along without your IP rights buttoned down, time to get that situation fixed. Don’t be slack on this. You might have to pay a high price if something goes wrong.

By the way, in all cases, in order for the contract to stick, a work-for-hire agreement or an express assignment needs to be accompanied by some payment of consideration to the person doing the work. This can be cash or stock or anything else of value. Don’t neglect this vital piece.

A final caution: General guidelines will help you spot problem areas but you will need a good business lawyer to help you evaluate them. Gray areas and exceptions to the rules abound. When it comes to your IP, work with a good lawyer to do things right.

High-level legal tips to consider when about to get acquired.

Startup Law 101 Series – Legal Tips to Consider When About to Get Acquired

Legal Tips When Getting Acquired

Here are some high-level legal tips for a seller to consider in anticipation of an acquisition:

1. Talk with your law firm/CPA firm about tax and structural issues up front, before you negotiate a term sheet. If you have a C-Corp with low-basis assets, an asset sale will leave you with a potential double tax hit. A stock sale or tax-free merger (A, B, or C type) is preferable in such situations but each has limits and restrictions on it – understanding the structural points up front will help considerably in how you negotiate the deal.

Term sheets may be legally non-binding but, you can bet, they will shape your deal all the way through to closing. Structure it right in the term sheet, then, and you will not be haunted by inadvertent blunders up-front that prejudice your deal throughout.

2. Watch out for duplicity. Use NDAs and be cautious about how and when due diligence is done to protect against a buyer’s gaining a lot of information about your company and then using it competitively against you after dropping the acquisition.

3. No-shop clauses are standard but keep them short and make sure they can only be extended by mutual consent.

4. In dealing with acquisition teams, make sure to do the primary negotiating with the key decision-makers so as to avoid getting the “two step” shuffle.

5. Beware of buyers who effectively seek an option to acquire your business without a real commitment. Don’t let a buyer inject slippery closing conditions coupled with open-ended opportunities to extend the closing. Make sure you can kill such a deal if it gets abusive.

6. Avoid earn-outs if at all possible – if you go with an earn-out, plan as if all you will see will be what you get at the initial closing. Exceptions obviously exist, but they are exceptions for a reason.

7. Try to limit trailing liabilities on the deal. Limit the size of hold-backs. Keep the reps and warranties as narrow as you or your lawyers can negotiate. Make sure indemnities have a short-term expiration date if possible.

Conclusion

When you want to get acquired, valuation is by far your most important issue. Investment advisors, VCs, and others can advise you on that.

Use these tips, though, to prod your thinking on the legal issues that can be important as well. Arm yourself and then work with a good lawyer to attend to details. These deals get complex and these tips barely touch on the issues that can arise. But they do give you a start.

For a much more detailed discussion of issues relating to the purchase or sale of a small business, see “What are some of the basic legal factors to consider in selling or buying a small business?” in the FAQ – Small Business section.