I’ve been a corporate lawyer for 17+ years, and there are certain fundamental legal mistakes that I’ve seen startups repeatedly make.  Accordingly, I thought it would be helpful to provide a simple checklist for startups, which includes links to prior posts for a more detailed discussion.  (This post was originally published as part of the “Ask the Attorney” series I am writing for VentureBeat.)

1.  Form a corporation — not an LLC (see post here) or a partnership (see post here).

2.  Incorporate in Delaware and qualify the company to do business in the state in which its principal office is located (see #2 here).

3.  Set-up vesting schedules for the founders (see post here) and file 83(b) elections with the IRS (see #3 here).

4.  Button-down IP ownership and assignment issues (see post here).

5.  Split the equity based on prior contributions and expectations going forward, not necessarily equally (see post here).

6.  If you hire any employees, make sure you don’t misclassify them as an independent contractor or fail to pay them at least the minimum wage (see post here).

7.  Only raise funds from “accredited investors” (see post here) and don’t pay anyone a commission for raising funds for you unless they are a registered broker-dealer (see post here).

8.  Put proper privacy policies in place and make sure you adhere to them (see post here).

9.  Don’t issue stock options unless a proper option plan is in place and a valuation has been done in compliance with Section 409A of the Internal Revenue Code (see post here).

10.  Don’t give your lawyers equity (see post here); don’t use your investors’ lawyers (see post here); and there are ways of cutting legal fees in half (see post here).

None of this is rocket science.  But as the late, great super-lawyer and VC Craig Johnson wrote in the book, The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship, “Starting companies is a lot like launching rockets: if you’re a tenth of a degree off at launch, you may be a thousand miles off downrange.”

Introduction

This post was originally part of the “Ask the Attorney” series I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Indeed, I am constantly being asked by entrepreneurs how they can lower their legal fees.  

Question

We launched our venture about six months ago, and we’ve been using a big Silicon Valley law firm to handle our legal work.  The problem is we’re getting killed on fees.  We just closed a $250,000 convertible note financing, and the bill was almost $13,000.  When I reviewed the invoice, I saw the partner was billing us at $740 an hour, a senior associate at $595 an hour and a junior associate at $350 an hour.  We like them and think they’re doing a good job, but we just can’t pay this much for legal.  Could you please give us some advice on what to do.  Thanks!

Answer

Here are three suggestions:

1.  Negotiate Lower Rates.  The first thing you should do is call the partner and tell him that you have a problem with the fees.  Most partners at the big firms have the authority to drop the hourly billing rates for startups (or to cut the bill).  As a negotiating tactic, you should try to get the partner excited about your venture and convince him or her that there will be lots of juicy work down the road.

You also should push to have one lawyer (preferably the partner) handle all your work going forward, not three.  Remember that lawyers are selling time.  The more time the lawyers bill, the better the sales numbers.  This business model thus rewards inefficiency, which is exasperated as you add more lawyers to your project.

You should also tell the partner you don’t want any junior associates handling your work.  With junior associates, you’re basically paying for their on-the-job training.  Plus, there is extraordinary pressure on associates to meet annual billable hour thresholds and bonus targets.  I saw all this first-hand as an associate for nearly eight years at two major law firms in New York City.

2.  Don’t Use a Big Law Firm.  Big firms are great for huge, complicated corporate projects – like an initial public offering, a tender offer or a public company merger.  These types of projects require a large team of lawyers (often with different specialties).

On the other hand, most of the legal work for startups (whether it’s a financing or a partnering agreement) can be handled by one experienced lawyer.  Thus, if you get push-back from the partner, go out and find a strong startup lawyer at a boutique firm (or a solo practitioner) to help you.  There are lots of good startup lawyers with 10-15 years’ experience who can handle your work at the same billable rates as junior associates at the big firms.

If you’re uncomfortable not using a “brand” name law firm or your investors push back, you can keep your big law firm for the big stuff, and use the startup lawyer to handle the day-to-day stuff.

The bottom line is that none of the startup work is rocket science, and using a big law firm is overkill.  It’s like using a jackhammer to clear hair out of your bathtub drain.

3.  Request Fixed Fees.  Finally, you should think about requesting fixed fees for your legal projects in order to align the law firm’s interests with your company’s.  Indeed, it’s time to destroy the billable hour.  The big firms are loathe to agree to this – but many innovative law firms (including my own) are disrupting the profession with this model.

It’s such an elegant solution: No more incentive for the law firm to be inefficient; no more overstaffing of projects; no more associates banging the file to meet their annual minimum billing requirements or bonus targets; and the best part for you, no more surprises at the end of the month when the invoice arrives.

Imagine if you had negotiated a fixed fee of $6,500 for your convertible note financing (which is quite reasonable); you could have cut your legal fees in half.

Conclusion

Obviously, the foregoing is a bit self-serving; however, it’s important for entrepreneurs to understand how the big firms work and alternative billing arrangements.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles).  Many thanks, Scott

Introduction

This post was originally part of the “Ask the Attorney” series I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.

Question

My co-founders and I are working on a cool new site, and we’ll be ready to launch in a few weeks.  I’ve been reading a lot on the web about incorporation and other legal stuff.  We have no money – so we’re going to do the legal ourselves.  Assuming we mess something up, are there any mistakes that can’t be fixed down the road?  We know that once we get money in we can clean things up, but we’re worried about mistakes that just can’t be fixed.  (And please don’t tell us to hire a lawyer.)

Answer

Below are four mistakes that could destroy your venture down the road if not handled properly today.

Vesting Restrictions.  The first deadly mistake relates to vesting restrictions.  Indeed, you must make sure that all of the shares of common stock issued by the corporation to the founders are subject to vesting restrictions – which means that ownership of the shares would vest over time (instead of all of the shares being owned outright on day one).  Otherwise, if one of the founders quits after a few months, he would take all of his shares with him.  In short, this is a nightmare scenario – particularly if there is bad blood with the other co-founders.

The only solution in such a scenario is to negotiate a repurchase of those shares, which could be very expensive or impossible (if the departing founder wants to screw with his co-founders).  And if the departing founder has a huge chunk of equity, it is unlikely that the company will find many sophisticated angels or VC’s interested in investing.

The most common vesting schedule is an equal percentage of stock (25%) every year for four years, on a monthly basis; however, it may be appropriate (for example, if the founders don’t know each other very well) to impose a one-year “cliff” (meaning that the first 25% tranche would vest on the one-year anniversary of the issuance date and then monthly thereafter).  In addition, sometimes a portion of the shares will be deemed to be vested “up front” – meaning that they are not subject to vesting — particularly where a founder has made a significant contribution prior to the company’s incorporation.

Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to execute and which would grant the company the right to repurchase any unvested shares (at the initial purchase price) at the time of the founder’s departure.  You also need to remember to file your 83(b) election with the Internal Revenue Service within 30 days after the grant/purchase date of the restricted shares (see tip #3 of my post “Founder Vesting: Five Tips for Entrepreneurs”).

IP Ownership.  There are three deadly mistakes that relate to intellectual property (IP) ownership, all of which usually surface when the investors conduct their due-diligence investigation:

1.  You must confirm that none of the founders’ prior employers has any rights to the venture’s IP because he or she was “moonlighting” while previously employed.  This is a particular concern if the startup is in the same space as a founder’s prior employer.

You should carefully review all employment-related agreements (e.g., offer letter, non-disclosure and inventions assignment agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to your startup’s IP.  If there is a problem, some employers will agree to execute a waiver, which you can show investors down the road.

2.  Any IP created or acquired by a founder (e.g., code, logo, domain name, etc.) prior to incorporation must be assigned to the company.  Usually this is done as part of the founder’s restricted stock purchase agreement, pursuant to which the IP is contributed as full or partial consideration for the shares of common stock issued to him or her in a tax-free transaction under Section 351 of the Internal Revenue Code.

Similar to the vesting issue above, a huge problem arises if one of the founders leaves prior to incorporation and takes his rights to the IP along with him; or if the assignment of IP is not properly made and the founder leaves prior to this issue being cleaned-up.  In both cases, the company is once again in the difficult position of trying to negotiate with a departed founder.

3.  You need to make sure that any IP created by outside developers (i.e., non-founders) is assigned to the company.  Sadly, this issue comes-up all the time — just ask the Winklevoss twins.  Indeed, had Mark executed an inventions assignment agreement, there probably would be no Facebook; or if there were, the twins’ (or their company) would own the IP.

This is a particular problem prior to incorporation.  The IP created by the developers often never gets assigned to the company either because there was no written agreement or because the company was not a party to the agreement (because it didn’t exist at the time).  Then when it’s time to fix the problem because investors are requiring it, the company needs to chase-down the developers (some of whom may be outside the U.S.) and start negotiating with them.

Conclusion

I hope the foregoing was helpful.  Another post that may be helpful is “How To Launch a Startup and Avoid Ending-Up in Jail.”  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles).  Many thanks, Scott

Introduction

For the past few months, I’ve been discussing the rights of VC investors in connection with preferred stock financings, including the following:

• liquidation preferences
• anti-dilution provisions
• dividends
• Board control
• protective provisions
• drag-along provisions
• pay-to-play and pull-up provisions
• conversion rights
• redemption rights

All of such rights are contractual in nature – that is, they are initially provided for in a term sheet and then incorporated into the definitive documentation.

There is, however, another set of rights with which many entrepreneurs may not be familiar: State law rights.  These are rights granted to stockholders pursuant to the respective laws of the company’s State of incorporation and are often the only rights that minority common stockholders have.  Indeed, whether a minority common stockholder is a founder, an advisor or even a friends/family investor, such stockholder will usually not be contractually granted any of the rights that are typically granted to preferred stockholders.

Accordingly, I thought it would be helpful to examine these non-contractual rights.  Because these rights are governed by State law, I will focus on the State of Delaware — where most companies are incorporated.

Rights of Minority Stockholders

Below are three significant rights of minority stockholders.

1)  Inspection Right.  A minority stockholder has the right to inspect the corporation’s stock ledger, a list of its stockholders and its other books and records (and to make copies of such items).  There are, however, certain formal procedural requirements that the stockholder must comply with, including making a written demand upon the corporation, “under oath” and stating a “proper purpose.”

Moreover, there are certain tricky evidentiary issues.  For example, if a stockholder merely seeks to inspect the corporation’s stock ledger and/or list of stockholders, the burden of proof is on the corporation to establish that the demanded inspection is for an improper purpose; however, if a stockholder seeks to inspect the corporation’s books and records, the burden of proof is on the stockholder to establish that the demanded inspection is for a proper purpose.

The Delaware statute defines “proper purpose” to mean “a purpose reasonably related to such person’s interest as a stockholder.”  Delaware courts have construed this language broadly to provide stockholders with a reasonable means to protect themselves (and their investment) – though the “proper purpose” must be sufficiently specific.

2)  Right to Bring a Derivative Claim.  A minority stockholder has the right to bring a derivative claim on behalf of the corporation, provided that certain “standing” requirements are met, including that he or she was a stockholder at the time the cause of action arose.  In a derivative claim, the recovery runs to the corporation, not to the stockholder individually.

Derivative lawsuits are generally brought when directors and/or officers of the corporation have breached their fiduciary duty owed to the corporation.  There are two broad categories of breach of fiduciary duty: a breach of duty of loyalty or a breach of duty of care.  For example, a minority stockholder could bring a derivative suit against a director or officer who allegedly used the corporation’s assets for personal gain (a breach of duty of loyalty).

The stockholder must typically first make a written demand on the corporation’s board of directors to be permitted to proceed with a derivative suit. The board can either accept or reject the demand.  Delaware law, however, recognizes a “futility” exception and excuses demand if the stockholder alleges particularized facts creating a reasonable doubt that the directors are disinterested and independent or that the challenged transaction “was otherwise the product of a valid business judgment.”

3)  Protection Against Oppression by the Contolling Stockholders.  Finally, minority stockholders have certain protections against oppression by the controlling stockholders.  Indeed, the controlling stockholders owe fiduciary duties to the minority stockholders.  As the leading Delaware case provides: “[W]hen a shareholder presumes to exercise control over a corporation, to direct its actions, that shareholder assumes a fiduciary duty of the same kind as that owed by a director.”

A minority stockholder may thus bring a direct claim (as opposed to a derivative claim) against the controlling stockholders for breach of fiduciary duty where, for example, the controlling stockholders have (i) forced the minority stockholders to sell their shares at a price below their fair market value; (ii) caused the corporation to issue additional shares of capital stock to the controlling stockholders at an inadequate price; or (iii) reduced the economic value of the minority stockholders’ shares disproportionately.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco).  Many thanks, Scott

I love working with startups – and trying to protect founders and watch their backs.  Not only are there key contractual issues that must be buttoned-down (like vesting and IP assignment), but also there is a minefield of laws and regulations that must be complied with.  Indeed, in a world of easy access to online documents, it is often this legal compliance which is overlooked by founders, as they attempt to stay “lean” and “scrappy” (and sometimes even handle the legal work themselves or through a web service).  As discussed below, however, non-compliance with certain laws could lead to founders’ criminal liability.

Potential Criminal Violations

Employment Laws.  The most common employment violations are (i) misclassifying an employee as an independent contractor and/or (ii) failing to pay an employee the minimum wage.  Both violations could lead to the same result: criminal liability for the failure to properly pay wages.

The key issue with respect to classification is control – the more control and supervision the startup exercises over the worker, the more likely he or she will be deemed an employee; for example, if a worker is required to show-up to the company offices at a certain time and work a certain number of hours every day under the supervision of the same company manager, it is unlikely the worker is an independent contractor.  And simply calling a worker a “consultant” or “independent contractor” in an agreement is irrelevant.

As I discussed in my recent post “How To Hire a Superstar Engineer for Your Startup,” startups may not give employees “sweat equity” in lieu of any ongoing cash payment/salary; nor may startups defer wages and other compensation.  In short, employees must be paid at least the applicable minimum wage (and typically, at least semi-monthly).

Moreover, as Chris Dixon reminded me, it is also unlawful for companies to hire illegal immigrants.  This is sometimes an overlooked issue for Web/tech startups — particularly those hiring engineers who are attending (or recently graduated from) a U.S. university.  Founders must insist on proper documentation prior to hiring foreigners (which is typically addressed in the offer letter).  And be forewarned: governmental audits of small businesses are clearly on the rise.

Privacy Laws.  It is imperative that startups have proper privacy policies in place and carefully adhere to them.  Needless to say, privacy has become a huge issue internationally and at the federal and state levels, and numerous hearings have been held in the U.S. Congress.  Indeed, Pandora disclosed in its recent IPO filing that it received a criminal subpoena in April “in connection with a federal grand jury…convened to investigate the information sharing processes of certain popular [smartphone] applications….”

Last year, three Google executives were held criminally liable in Italy for an online video of an autistic teenager being bullied – and they were given six-month suspended sentences.

Moreover, certain states have criminal libel laws for web defamation, which generally means posting false information about someone that defames them (such as marital infidelity, criminal activity, etc.)  Colorado state law, for example, makes criminal libel a felony carrying up to 18 months in prison and a fine up to $100,000 for the first offense.

Tax Laws.  One of the most common violations of tax laws by startups that could lead to the criminal liability of a founder is the willful failure to “pay over” payroll taxes withheld from employees.  For example, in January 2010, the U.S. Court of Appeals for the 10th Circuit affirmed the conviction and 37-month prison sentence of a business owner who failed to deposit withheld payroll taxes with the IRS.

Similarly, if a startup collects sales taxes from its customers and then fails to remit it to the applicable state taxing authority, founders could be charged with theft of state funds.

Obviously, the failure to pay applicable federal and/or state income taxes could lead to criminal liability.

Securities Laws.  Finally, a violation of applicable securities laws could result in criminal liability.  Some of the most common securities laws violations by startups are (i) making materially false or misleading statements in connection with the offer or sale of securities; (ii) retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) that offer and/or sell securities on a startup’s behalf for a commission; (iii) advertising, or improperly soliciting investors in connection with, the offer or sale of securities, including via email, Twitter or Facebook; and (iv) improperly offering and/or selling securities to “friends and family” who are not “accredited investors.”

Conclusion

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco).  Many thanks, Scott

Video streaming by Ustream

For those of you who want to skip the video, here are the mistakes I discuss:

1.  83(b) Elections.  Some founders make the mistake of not making an “83(b) Election” in connection with the restricted stock (i.e., stock subject to forfeiture) issued to them.

Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock to the grant date, rather than the vesting date.  As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock were purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.   Such an election is made by filing a simple, one-page election with the IRS within 30 days after the grant/purchase date (no exceptions applicable).   I discuss this issue in detail in paragraph 3 of my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

2.  Employment Issues.  Some startups make the mistake of not addressing employment-related issues with respect to new hires.

For example, if an employee is hired by a startup, he or she generally should be required to execute two documents: (i) an offer letter and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.  In addition, some startups make the mistake of hiring an employee and merely giving him or her “sweat equity” in lieu of any ongoing cash payment/salary.  Unfortunately, this is illegal in California and could lead to criminal liability.  I discuss these issues in paragraph 8 of my blog post “Launching a Venture: Ten Tips for Entrepreneurs.”

3.  Intellectual Property Issues.  Some startups make the mistake of not adequately protecting their intellectual property (or “IP”).

Indeed, for many start-ups, IP such as trademarks, domain names or patents is their most valuable asset.  Accordingly, a number of steps should be taken to protect IP assets, including (i) developing a comprehensive strategy for IP; (ii) establishing and implementing IP policies and procedures — e.g., concerning proper use of third parties’ IP; (iii) if appropriate for the business, filing patent applications and registering copyrights, trademarks and domain names; and (iv) as discussed above, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements.  I discuss these issues in detail in my post, “What Are the 5 Biggest Mistakes that Startups Make Regarding IP?”

4.  Stock Option Plans.  Some startups make the mistake of issuing shares of common stock (as opposed to stock options) to new employees.

This is a problem because of the potential tax liability.  Unless the employee purchases the shares for their fair market value, the issuance will be deemed compensation to the employee; and he or she will have to pay ordinary income tax at the federal and state level, and the company will have tax withholding obligations.  There are also tricky securities law issues. Accordingly, in order to attract and retain key employees (and to conserve cash), it usually makes good business sense for the company to establish a stock option plan.  I discuss these issues in detail in my post, “Issuing Stock Options: Ten Tips For Entrepreneurs.”

5.  Due Diligence.  Finally, some startups make the mistake of not diligencing the guys or gals on the other side of the table.

Indeed, whether a startup is doing a financing, a partnering agreement or some other transaction, it must investigate the other party.  This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom it is dealing.  Who are these guys?  Are they good guys or are they jerks?  Can they be trusted?  When they say they are going to do something, do they do it?  Do they add value?  Remember, in certain deals (such as an angel or venture capital financing), the startup will, in effect, be married to the firm and the individuals for a number of years.  I discuss this issue in detail in paragraph 1 of my blog post “Five Mistakes Entrepreneurs Make in Dealmaking – Part I.”

Video streaming by Ustream

For those of you who want to skip the video, here are the mistakes I discuss:

1.  IP Ownership.  Some entrepreneurs make the mistake of creating IP for their new venture while they are still working for someone else.  They then quit and launch their startup, not realizing that the IP is actually owned by their prior employer.  This is a tricky issue, and you should carefully review all employment-related agreements to determine if there are any provisions that may inhibit your new venture, including IP ownership.  I discuss this issue in detail in paragraphs 2 and 4 of my blog post regarding formation issues (part 2).

2.  Choice of Entity.  Some entrepreneurs make the mistake of forming the wrong entity.  Investors generally invest only in corporations – not LLC’s or partnerships.  You should thus form a corporation – and consult with an accountant as to whether you should make an S corporation election (and then convert to a C corporation down the road).  I discuss the issue of choice of entity in detail in my blog post “Choice of Entity for Entrepreneurs.”

3.  Place of Incorporation.  Some entrepreneurs make the mistake of incorporating the company in the wrong state.  You should incorporate in Delaware – that’s what investors generally require.  You should then qualify the company to do business in California and/or any other State in which it is “doing business.”  I discuss this issue in paragraph 1 of my blog post regarding formation issues (part 1).

4.  Vesting Restrictions.  Some startups make the mistake of issuing stock to co-founders without imposing vesting restrictions.  Then, one of the founders ends-up leaving in a few months and keeps all of his or her equity.  You should make sure you and your co-founder execute a restricted stock purchase agreement with reasonable vesting schedules (typically four years) upon the issuance of the company’s stock.  I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

5.  Securities Law Issues.  Some startups make the mistake of not complying with applicable securities laws; for example, they issues shares to “friends and family” who are not “accredited investors” without proper disclosure documents; or they retain a consultant who is not a registered “broker-dealer” to sell company stock for a commission.  You should be very careful when issuing any kind of securities; non-compliance could cause severe consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.  I discuss this issue in detail in paragraphs 2 and 4 of my blog post “Five Common Mistakes Entrepreneurs Make in Raising Capital.”

6.  Splitting Equity.  Some startups make the mistake of splitting equity equally between or among the co-founders.  The splitting of equity is a significant business decision which must be negotiated between or among the co-founder based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally may sound fair on its face, but it’s usually not the correct decision.  I discuss this issue in detail (and the various factors to consider) in my blog post “Ask the Attorney – Splitting Equity.”

I just finished reading the book Do More Faster, which is a collection of blog posts/articles by successful entrepreneurs and investors edited by David Cohen, the founder and CEO of TechStars, and Brad Feld, the managing director of Foundry Group.  As Brad noted on his blog: “Our goal was to write a unique book full of useful information for any early stage entrepreneur.  Rather than give advice or simply tell an entrepreneurial success story, we decided to blend the experience of the TechStars entrepreneurs and the TechStars mentors in an organized fashion.”

Below are a few nuggets from the first half of the book; I will share some second-half quotes in my next post.  Cheers, Scott

Solid Quotes

• “There are few things as rewarding as starting a business from nothing, creating jobs and building something that matters.” –Mark Pincus, co-founder and CEO of Zynga (Foreward, p.xi)
• “If you have a brilliant idea, it’s safe to assume that a few very smart people are working on the same thing….” –Tim Ferriss, best-selling author and serial entrepreneur (p.4)
• “When you’re selling a solution to a problem and you find that nobody is saying no to your prices, you’ve found some serious pain.” –Isaac Saldana, founder and CEO of SendGrid (p.11)
• “Getting feedback and new ideas is the lifeblood of any startup.  There is no point in living in fear of someone stealing your idea. . . . [Y]ou can steal ideas, but you can’t steal execution.”  -Nate Abbott and Natty Zola, co-founders of EverLater (p.15)
• “Usage is like oxygen for ideas.  You can never fully anticipate how an audience is going to react to something you’ve created until it’s out there.  That means every moment you’re working on something without it being in the public arena, it’s actually dying, deprived of the oxygen of the real world.” –Matt Mullenweg, founder of Automattic (creator of WordPress) (p.21)
• “Focus on the smallest possible problem you could solve that would potentially be useful.” – Ev Williams, co-founder of Twitter (p.24)
• “Instead of just assuming that we knew what our users were doing, we figured it out by carefully monitoring our logs and studying our analytics.” –Darren Crystal, co-founder and CTO of Photobucket
• “As long as I listen to my customers, I never need to have another original idea.”  -Niel Robertson, founder and CEO of Trada (p. 35)
• “Build the smallest possible product that allows you to test assumptions and answer questions about your business, and then get it out there.” –Sean Corbett, co-founder of HaveMyShift (p.37)
• “Creating a company is really hard and there is way more work than you can even begin to grasp.  Having someone to share your burden, walk side by side with you into battle, and sing you show tunes when you’re feeling blue is invaluable.” – Mark O’Sullivan, founder & CEO of Vanilla (p. 65)
• “I was so obsessed with the idea for oneforty that I literally couldn’t quit.  I had to see it come to light…  If you can’t quit no matter how hard you try, then you have a chance to succeed.” –Laura Fitton, founder & CEO of oneforty (p.80)
• “Salespeople hunt pink Cadillacs. Startups seek friends.” –Micah Baldwin, CEO of Graphic.ly (p. 88)
• “You can literally feel it when you walk into a great startup culture. The room has energy.  There’s a buzz. Doors are open. Whiteboards are filled with hieroglyphics.  People are getting stuff done.  Meetings are short and to the point.”  –Greg Gottesman, managing director of Madrona Venture Group (p. 98)
• “[L]iving the startup life requires both art and science and is simultaneously qualitative and quantitative.  Take all the inputs you can gather and then make the decisions that feel right to both your head and your gut.”  -Ryan McIntyre, co-founder of Excite.com and Managing Director at Foundry Group (p. 130)
• “For a startup, having great sales DNA is a wonderful asset.  But at the early stages, it can devour the company’s future.” –Eric Ries, author of The Lean Startup Methodology (p. 134)
• “Remember that human nature has a tendency to admire complexity, but to reward simplicity.  Complexity has an inverse effect on the ability to scale your business.  The more complicated you make your business, the harder it is to expand it.” Ben Huh, CEO of The Cheezburger Network (p. 146)
• “[D]on’t hide your failures. Wear them as a badge of honor. And most of all, learn from them.” –Fred Wilson, Managing Partner at Union Square Ventures (p. 160)

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section (or via the “Ask Scott Any Question” link if you prefer confidential treatment).  Many thanks, Scott

Question

I’m the founder and CEO of a successful startup and we’ve been trying to sell certain non-core assets (including some IP) to a competitor.  Their CEO sent me a letter of intent, which I signed and emailed back to him last week.  Now I just received a much better offer from another company and was wondering if I can back out of the first deal.  I read some articles on the web that letters of intent are non-binding – so I just wanted to make sure.

Answer

Whether a particular letter of intent (LOI) — sometimes referred to as a “term sheet” or “memorandum of understanding” — is binding or not depends upon the precise language used in the LOI and the actions of the parties.  Indeed, parties typically do not want an LOI to be binding because many of the material terms of the deal have not been negotiated (and they do not want a Court to start filling-in the terms in the event of litigation).

There may, however, be certain provisions that the parties do want to be binding.  For example, in the acquisition context, the acquiror would generally want to prevent the seller from shopping the deal subsequent to the execution of the LOI.  Accordingly, a so-called “no shop” provision is generally included in the LOI and deemed binding.  Here are three tips regarding LOI’s:

Use Clear, Consistent Language.  LOI’s are sometimes drafted and signed by business people without vetting by the lawyers.  As a result, one party often finds itself in the awkward position of having a binding agreement on its hands when that was never the intent.

As noted above, the language in the LOI is critical in determining whether an LOI is binding.  If you don’t want an LOI to be binding you must include very specific language to the effect that:

This letter is merely an expression of intent and is intended to serve as a basis for negotiating a definitive agreement and the related documents; it does not constitute, and will not give rise to, any legally binding obligation on the part of the parties hereto and is expressly subject to the execution of such agreement and documents.

The letter should also include words such as (i) “would” (e.g., “the purchase price would be $_____) as opposed to “shall” or “will”; and (ii) “this proposal” or “the possible transaction” as opposed to “this agreement” or “the deal”.

If any provisions will be binding, you should add clear language to the effect that: “Notwithstanding anything in this letter to the contrary, the following obligations will be binding on the parties hereto:”

Act in a Manner Consistent with the LOI.  Not only is the language in the LOI critical in determining whether a binding agreement has been reached, but also the actions of the parties post-signing.  Indeed, many startups have gotten themselves into trouble when, despite the language in the LOI that it is non-binding, they have acted as though an agreement has been reached.  For example, if the LOI is “non-binding,” you should not be having drinks to “celebrate the deal” or you should not be sending “congratulatory” emails.  Nor should there be any partial performance by any party.

Include Language That There is No Duty to Negotiate in Good Faith.  It is generally advisable to include language in the LOI to the effect that: “Neither party hereto has an obligation to negotiate a definitive agreement in good faith.”  This is because many courts have imposed a duty to negotiate in good faith in connection with LOI’s and the related negotiations (even if the LOI is silent with respect to this issue).

Accordingly, you don’t want to run the risk that you walk away from a “non-binding” LOI and terminate negotiations thinking that there’s no problem – only to be handed a summons and complaint suing you for failure to negotiate in good faith.  This is a gray area and big companies (with deep pockets) can exploit this issue if you’re not careful.

Conclusion

I hope the foregoing is helpful.  My advice to my clients is to have all LOI’s vetted by counsel prior to execution.  Indeed, the common practice in New York among sophisticated M&A practitioners is simply to create a bullet-point list of agreed-upon terms — and not to execute an LOI.  As I discuss in my post “Ask the Attorney – Acquiring a Company (Part 1),” exclusivity can be handled via a separate exclusivity letter.

This post is part 3 of my three-part series: “How do I raise seed capital if I don’t know any investors?”  In part 1, I discussed the importance of hustling and building relationships in order to get warm introductions to investors.  In part 2, I discussed some of the different mentorship and seed capital programs, including Y Combinator and TechStars.  In this post, I will discuss applying directly to a relatively new site called “AngelList.”

What is AngelList?

AngelList is a free service founded by Naval Ravikant and Babak Nivi of VentureHacks, which provides pre-screened startups with introductions to angel investors.  Naval is a smart entrepreneur and angel investor whom I just met in person this past Thursday at the Women’s 2.0 Pitch Conference in San Francisco.  Nivi is equally impressive, and I had the pleasure of working with him earlier this year in connection with my two sponsored posts on VentureHacks: “5 New Year’s Resolutions for Closing Deals in 2010” and “Top Ten Reasons That Entrepreneurs Hate Lawyers.”

As the Wall Street Journal noted:

AngelList, started in February by angels Naval Ravikant and Babak Nivi, vets dozens of deals before highlighting the best ones in emails each week sent free to a group of 200 investors.

Messrs. Ravikant and Nivi—who also run Venture Hacks, a for-profit site that provides advice to start-ups—say they have received pitches from more than 1,000 start-ups, mostly consumer Internet companies. Of the 48 companies featured so far on AngelList, about half have received funding, they say.

Accordingly, if you’re a startup seeking seed capital, you can apply to AngelList via their online application; and, if you are chosen as an appropriate investment opportunity, you will be introduced via email to an extraordinary list of angels.  As Naval and Nivi advise on the site, “[w]e look for the same things that early-stage investors look for: traction, social proof, and team.  You don’t need all 3, but you need to kick ass in at least one of them.”

The founders of BlockChalk wrote an excellent post, “Lessons From Raising a Seed Round” about how they secured funding via AngelList.  Here are a few highlights:

The team is key

We found that the makeup of our founding team contributed directly and measurably to our ability to raise funds. . . .

It’s hard to go it alone. It’s probably also not smart in most cases. A powerful team is greater than the sum of its parts, and investors know that.

Always be tweaking

We never stopped tweaking our pitch. Every meeting we had was an opportunity to both audition our latest pitch and to gather feedback for the next iteration. . . .

Prototypes will love you and leave you

There is no substitute for real feedback from real users. . . .

If we could do it again we might have launched our prototype under a different brand. Or perhaps emblazoned it with the word “beta”, or even “alpha”. But at some level this is the price you pay for having a “product” before you have funding. Prototyping is a double-edged sword. Be prepared for both blades!

Gagan Biyani, the Co-Founder and President of Udemy (whom I discussed in part 1 of this series with respect to his extraordinary hustle) also gives very high marks to AngelList in his post, “Udemy’s $1M Fundraising: Lessons Learned about Pitching Investors from a First-Time Entrepreneur”:

We can’t speak higher of AngelList and the value it provided to Udemy’s fundraising process. We received over 25 intro’s to top-tier investors. What other way can you get 25 investors to ask for intros to YOU! AngelList led to investments from Jeremy Stoppelman (CEO of Yelp), Dave McClure (500 Startups), Josh Stylman (Angel Investor, co-founder at Rotomedia and Reprise Media), and Ben Ling (executive roles at Google, Facebook, YouTube).  But what was even more important was that AngelList got our round over-subscribed, so we had momentum which helped convince our other investors to make their decisions faster and in our favor.

Rafael Corrales, the co-founder of LearnBoost and a very scrappy and highly-intelligent entrepreneur, discusses AngelList at the 33:10 mark in this mixergy.com video.  Indeed, in terms of the role that Nivi and Naval play, Rafael specifically notes that:

Nivi, even Naval, would hop on the phone and say, hey, here’s how you can think about this. Here’s an interview that we did that we haven’t even released publicly. This will help you. That will help you. Go talk to this guy.

And so, these guys were basically, while we were fundraising, really hands on coaches, and it’s really great coming from them because they’re basically these really incredible guys who know exactly what they’re talking about. And they’re biased in your favor. So, they’re going to try to help you find ways to solve your problems in ways that are beneficial to the entrepreneur as opposed to, maybe, meeting with, a hypothetical example, meeting with someone at a VC firm who is going to have more biased advice.

And so, these guys are sort of more independent or, at least, biased in your favor. And so that’s really how they can help is prep you for meetings, help you with your pitch. And then, ultimately it’s also on the entrepreneur to go to VentureHacks.com and read all the blog posts that they’ve done because those resources are incredible.

Finally, if you would like to learn more about AngelList, you can check out some of the answers on Quora to the following questions:

• What do people think of AngelList?

• Which startups have been funded via AngelList?

• How do venture capitalists feel about AngelList taking all the prime deals and leaving them with the leftovers?

Conclusion

In conclusion, it is clear that AngelList is a great place to go if you’re an entrepreneur seeking to raise seed capital.  I would also recommend applying to Open Angel Forum, which was founded by Jason Calacanis, a highly-successful serial entrepreneur and super angel, in response to his disgust with angel groups charging entrepreneurs to pitch.  Indeed, I am a big fan of Open Angel Forum and have not only been a sponsor, but also wrote a poem about my experience at one of the events: “Ode to OAF: A Personal Tribute to Jason Calacanis, Tyler Crowley and the Angels.”  Cheers, Scott

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.

Question

I’m a first-time entrepreneur, and I’ve been working on a new e-commerce site for about six months.  I outsourced the development work, but now I’m thinking it would be better to bring on a technical co-founder to handle that work.  What are some of the mistakes you’ve seen a sole founder like me make hiring a co-founder.  Any advice would be appreciated.  Thanks!

Answer

Here are five common mistakes that I’ve seen:

Mistake #1 — Adding a Co-Founder You Don’t Know or Trust.  Choosing a co-founder is probably the most important decision you will make in connection with your venture.  Ideally, it should be someone that you know really well and whom you trust (like a close friend) – i.e., someone you are confident will be in the trenches with you fighting and clawing when the going gets tough (and believe me it will).

Some first-time entrepreneurs make the mistake of hiring a co-founder whom they have just met (e.g., at a conference) or who is a total stranger.  Simply put, that makes no business sense.  You have to treat hiring a co-founder like you’re getting married – and obviously you don’t marry someone unless you know him/her very well and trust and respect them.

Mistake #2 — Issuing Too Much Equity.  Some entrepreneurs make the mistake of giving their co-founder too much equity — sometimes as much as 50%.  Indeed, splitting the equity equally between co-founders is usually not the right business decision — particularly where it’s your idea and you’ve already spent six months on the venture.

The splitting of equity is a significant business decision which must be negotiated between co-founders based upon their respective contributions to date and their expectations going forward.  In this context, you should probably be thinking in the 20-25% range, assuming the co-founder will be adding significant value.  I discuss this issue in detail in my blog post “Ask the Attorney – Splitting Equity.”

Mistake #3 — Not Imposing Vesting Restrictions.  Some entrepreneurs make the mistake of issuing stock to their co-founder without imposing vesting restrictions.  This becomes a huge problem if the co-founder leaves shortly thereafter.  Indeed, it would be inherently unfair if your co-founder quit in six months and kept all of his equity.

To prevent this, you must make sure that your co-founder executes a restricted stock purchase agreement, with a vesting schedule which grants him ownership of his stock over a four-year period (typically on a monthly basis).  If you don’t know your co-founder very well, you should also think about a “one-year cliff” – meaning he would not be entitled to his first 25% tranche until he has worked for the company for at least one year.  I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

Mistake #4 — Not Requiring the Execution of Employment Documents.  Some entrepreneurs make the mistake of hiring a co-founder, but not requiring him or her to execute (i) an offer letter agreement and/or (ii) a confidentiality and invention assignment agreement.  The offer letter will set forth all of the co-founder’s rights and obligations, including that the relationship is “at will.”  The confidentiality and invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by your co-founder is legally owned by the company.

Non-competition provisions may also be appropriate in certain circumstances; however, such provisions are unenforceable in California other than in the context of the sale of a business — though California courts may enforce contractual provisions that prohibit employees from soliciting the company’s employees, provided that such provisions are reasonable in scope and duration.

Mistake #5 – Not Complying with Applicable Securities Laws.  Some entrepreneurs make the mistake of not complying with applicable securities laws in connection with the issuance of stock to a co-founder.  The bottom line is any time a company issues securities it must comply with both state and federal securities laws; non-compliance could cause severe consequences, including a right of rescission for the co-founder, injunctive relief, fines and penalties, and possible criminal prosecution.  Complying with securities laws with respect to issuing stock to a co-founder is generally not onerous (particularly in California); however, you definitely need to get a lawyer involved – particularly if the co-founder will be paying more than a nominal amount for his stock.

Conclusion

I hope the foregoing is helpful.  You should also check out this solid post by Jason Baptiste: “What to Look For In a Technical Co-Founder.”  Many thanks, Scott

This post is part 2 of my three-part series: “How do I raise seed capital if I don’t know any investors?”  In part 1, I discussed the importance of hustling and building relationships in order to get warm introductions to investors.  In this post, I will discuss a different approach: applying to one of the mentorship/seed capital programs.

Mentorship and Seed Capital Programs

A very exciting and relatively recent development in the startup world is the proliferation of mentorship programs for entrepreneurs.  Indeed, these programs typically include not only teaching and coaching, but also seed capital (as well as introductions to investors).  Thus, for first-time entrepreneurs who have little experience, money or contacts, these programs offer a “win, win, win” opportunity.  Below is a brief description of the top three programs.

1) Y Combinator

Y Combinator (YC) was founded in 2005 by startup guru and essayist Paul Graham and author Jessica Livingston and is the crème de la crème of mentorship programs.  As noted on the Y Combinator website:

Y Combinator does seed funding for startups.  Seed funding is the earliest stage of venture funding.  It pays your expenses while you’re getting started. . . . We make small investments (rarely more than $20,000) in return for small stakes in the companies we fund (usually 2-10%).

YC runs two three-month programs per year: one from January through March and the other from June through August.  Entrepreneurs  must move to the Silicon Valley area to participate.  As Paul discusses at length in his essay, “What Happens at Y Combinator,” each program includes (i) weekly “dinners” with successful startup founders as speakers; (ii) “office hours,” which comprises unlimited individual conversations with the YC partners over the course of the program (and half of the founders’ time); (iii) “Angel Day,” at which each startup is paired with two angel investors who will meet with the founders regularly thereafter; and (iv) “Demo Day,” the program’s culmination – a three-day event, with 4+ presentations to an audience of approximately 400 (including many of Silicon Valley’s top investors).

YC has funded over 200 startups, including Loopt, Reddit, Wufoo, Scribd, Disqus, Dropbox, Justin.tv and Posterous.  You can apply to YC here; and check out their FAQ’s here.  (See also “How Y Combinator Is Remaking Silicon Valley in Its Image.”)

2) TechStars



TechStars is a similar three-month program, which was founded in 2007 by investors David Cohen and Brad Feld; it is offered once per year in four different cities: Boulder, Boston, New York and Seattle.  Startups receive up to $18,000 in seed funding for a 6% equity stake, intensive mentorship and the chance to pitch to investors at the end of the program.

As noted on the TechStars website:

About two or three nights a week, we’ll organize informal educational sessions with our mentors.  We also expect many of the mentors to drop in to TechStars at various times throughout the program.  In general though, you’ll be working on your product each day, just like all of the other founders in the program. We don’t tell you what to do or when, but we create an environment that is conducive to helping your startup every day.  And we’ll make sure you have lots of experienced mentors around to help you.

TechStars provides a detailed web list of all companies that have participated in its programs, together with their full historical results.  There is also a 5 minute video by Current TV which provides a sense of what TechStars is like, and you can watch “The Founders,” which consists of 14 five-minute episodes that follow three teams through the 2009 program.

You can apply to TechStars here; and check out their FAQ’s here.

3) The Funded Founder Institute

Founder Institute (FI) was founded by Adeo Ressi, a serial entrepreneur and founding member of TheFunded, Incorporated, in 2009 and is different from YC and TS in the following material respects.  First, rather than receive seed capital, entrepreneurs are required to pay a $50 application fee and a $900 course fee upon acceptance.

Second, FI takes a small percentage (3.5%) of warrants in the startup, which provides FI with an option to buy stock at the price set during the company’s first qualified financing round; warrants are deposited in a “Bonus Pool” that is shared among the other founders, the mentors, the local operators and FI.

Third, if the startup is successful and receives financing in excess of $50,000, it is “asked” to pay FI a one-time “Tuition Fee” of $4,500. And, finally, FI only requires a commitment of approximately 15 hours per week (a mandatory three-and-one-half-hour weekly session and between five and ten hours of assignment work that needs to be completed before the following session).

FI currently offers programs twice per year in Silicon Valley, Singapore, Seattle, Los Angeles, San Diego, Denver, Houston, Boston, New York, Washington DC, Paris, Brussels and Berlin.  As noted on the FI website:

The Founder Institute is a technology startup accelerator and entrepreneur training program currently on pace to launch over 500 companies per year in over 13 cities worldwide.  The program identifies high-potential entrepreneurs using predictive social science testing, and then guides them through weekly company-building sessions featuring a network of over 250 CEO Mentors.  All program stakeholders, including the participating founders and CEO Mentors, share in the equity generated by companies formed in the program.  In addition, participants get access to free and discounted services, and are not required to quit their day job.

You can apply to FI here; and check out their FAQ’s here.

4) Other Programs.  Below are some of the other mentorship programs:

ShotPut Ventures – Atlanta, GA

Capital Factory – Austin, TX

LaunchBox Digital – Durham, NC

SeedCamp – London (and mini-events throughout Europe)

Launchpad LA – Los Angeles, CA

DreamIt Ventures – Philadelphia, PA

Conclusion

I hope the foregoing was helpful.  Next week, in part 3, I will discuss applying directly to angel groups, such as AngelList and Open Angel Forum.  If you have any questions, please feel free to call me directly at 415-979-9998.  Many thanks, Scott

]]> http://walkercorporatelaw.com/entrepreneurship/how-do-i-raise-seed-capital-if-i-don%e2%80%99t-know-any-investors-%e2%80%93-part-2/feed/ 2 http://walkercorporatelaw.com/startup-issues/how-do-i-raise-seed-capital-if-i-don%e2%80%99t-know-any-investors-%e2%80%93-part-1/?utm_source=rss&utm_medium=rss&utm_campaign=how-do-i-raise-seed-capital-if-i-don%25e2%2580%2599t-know-any-investors-%25e2%2580%2593-part-1 http://walkercorporatelaw.com/startup-issues/how-do-i-raise-seed-capital-if-i-don%e2%80%99t-know-any-investors-%e2%80%93-part-1/#comments Wed, 13 Oct 2010 19:44:48 +0000 Scott Edward Walker http://walkercorporatelaw.com/?p=1430 Introduction

As a corporate lawyer for entrepreneurs, I am constantly asked by first-time entrepreneurs: “How do I raise seed capital if I don’t know any investors?”  That’s a good question, which I’m going to answer in three parts.  This post is part 1 – hustle and build relationships.

Hustle and Build Relationships

Simply put, if you’re looking for seed capital, but don’t know any investors (and don’t have any family members or friends to help you out), you need to hustle and build relationships.  The goal is to get “warm” introductions to investors – i.e., an introductory phone call or email from a middleman whom the investor trusts and respects.  It takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

As Gagan Biyani, the Co-Founder and President of Udemy (and a very impressive entrepreneur) explains in his post, “Udemy’s $1M Fundraising: Lessons Learned about Pitching Investors from a First-Time Entrepreneur”:

I went to every conference I could and literally killed myself while there.  I attended tons of networking events and met as many entrepreneurs and investors as I could. While at events/conferences, I rarely ate dinner because I was too busy schmoozing and grabbing business cards.  During the weekdays, I’d spend hours e-mailing potential [investors] to start using Udemy. . . .

Though nobody could tell, this was one of the hardest times in my life. We had just failed at raising money and I had barely 6 months until I’d be out of cash. Nobody in the tech community knew who we were and we were getting little traction with users. I never went out; rarely saw my friends or family and sat in front of a computer all day and night. It was tough.

David Hornik, a partner at August Capital and a very smart investor, confirms this approach in his recent interview on Sprouter:

So if you are new to the area or to entrepreneurship, how do you get the right . . . intros? What you need to do is build relationships from the bottom up.  Spend a ton of time meeting people, talking with them about what they are working on, and sharing what you are working on.  Over time you will find people with whom your idea resonates and they will introduce you to folks with whom they are close.

Indeed, in his book “Mastering the VC Game,” Jeffrey Bussgang, a general partner at Flybridge Capital Partners, explains how he got an introduction to superstar VC John Doerr of Kleiner Perkins when he was a first-time entrepreneur:

[W]hen we started Upromise, Michael Bronner and I knew we wanted to get to John Doerr.  We networked to him through three sources – one of my [Harvard Business School] professors who knew him well, a Silicon Valley CEO friend of Michael’s who knew him, and a Fortune 500 CEO with whom Michael was friendly.  After hearing from us from these trusted sources, even a guy as busy as John Doerr decided it was worth taking a meeting.

Conclusion

I hope the foregoing is helpful.  I love the quote from Gary Vaynerchuk (the founder of Wine Library TV and the so-called “Social Media Sommelier”) in his speech at the Web 2.0 Expo in New York: “Hustle is the most important word – ever.”  That says it all.  Gary goes on to explain that: “I used to work in a liquor store from 7 in the morning until 10 at night for seven straight years, and the only days-off I took were to watch the New York Jets.” [starting @ 3:16 mark]

That’s the kind of effort it’s going to take to raise money and execute your business model.  Next week, in part 2, I will discuss applying to mentorship programs such as Y Combinator, TechStars and the Founder Institute, which also provide seed capital to startups.  If you have any questions, please feel free to call me directly at 415-979-9998.  Many thanks, Scott

As a corporate lawyer for entrepreneurs, I am often asked to review pitch decks.  A “pitch deck” is a collection of PowerPoint slides created by an entrepreneur in order to raise funds from (i.e., “pitch”) investors.  They can be sent to investors as a stand-alone document (e.g., via email) or they can be used in conjunction with an in-person presentation.  I am generally happy to give my input with respect to pitch decks — with the caveat that I’m a lawyer, not an investor.  That being said, here are five common mistakes that I see:

Mistakes

Mistake #1 — Too Many Slides.  Having too many slides is probably the number one mistake that entrepreneurs make.  I recommend 10 slides or less.  Indeed, Fred Wilson, a highly-successful and well-respected VC, recommends six slides in his post here and aptly points out that:  “Like many things in life, less is more in fundraising slides. You can explain your business in mind numbing detail or you can inspire an investor and let them imagine. Guess what works better?”

Mistake #2 — Too Many Words.  Most decks not only have too many slides, but also too many words.  Decks should be as visual as possible (with charts, tables and pictures) so that each slide can convey its purpose in 5 seconds, not 30 seconds.  Investors are not interested in reading memos, with rows of bullet-points (nor are they interested in hearing you read memos to them).  Remember the old Chinese proverb: “a picture is worth one thousand words.”

Mistake #3 — Failing to Tell a Story.  Another common mistake is failing to tell a compelling story.  Like everyone else, investors love stories; it’s in our DNA going back to the early humans sitting around a campfire.  So tell an exciting story about your startup and arrange your slides to reflect that story.  As the guys at Venture Hacks describe in their excellent e-book Pitching Hacks:

This sequence of slides tells a story:

We have a mission and a team that is taking us there. Why? We discovered this large problem and solved it with a product that has this amazing technology inside. We’re going to market and sell it to these customers, with these advantages over our competitors.  In particular, we’re working towards these milestones over the next few quarters. In conclusion, this financing is a great investment opportunity.

This is a good sequence for a written deck.  But don’t take this sequence too literally when you’re presenting.

Mistake #4 — Not Identifying A Big Problem.  You’re not going to get investors excited unless you have identified a big problem (or opportunity) in the marketplace.  You must address this issue head-on in your pitch deck:  What’s the big problem?  What’s the solution?  This is the core of your pitch and this is where your demo comes in, as discussed below.

Indeed, as Randy Komisar of Kleiner Perkins notes in the Forbes article, “Seducing A VC”:  “In my business, I look for the biggest problem because the amount of resources, time and money that go into solving a small problem is pretty comparable to the amount of resources that go into solving a big problem.  Why not solve a big problem?”

Mistake #5 — No Product Demo.  A final common mistake is not demonstrating your product.  If you’re presenting in person and you’re pitching a product, you must demo the product first thing.  Indeed, demos trump every form of presentation.  As Jason Calacanis, a very smart and successful entrepreneur (and angel investor) notes in his blog post, how to demo your product (part one):

The longer it takes for you to show your product, the worse your product is.  Folks who have a kick-ass product don’t spend five or ten minutes “setting the stage” or “giving the background.”  Folks with killer products CAN’T WAIT to show you their product. Their demos start with their homepage and quickly jump into the users experience. If a picture tells a thousand stories, then a product demo tells a million.

Conclusion

Most of the foregoing is covered in an excellent article, Perfecting Your Pitch, by Guy Kawasaki, managing director of Garage Technology Ventures, co-founder of Alltop and a smart investor and marketing guy.  In addition, I have set forth below a good example of an effective pitch deck via Dave McClure, another smart investor and the founding partner of 500 Startups (though there may be too many slides and, as Dave notes, the demo should be done first).  Many thanks, Scott

The purpose of this post is expand upon my answer to the question on Quora:

“What should you do as a startup when a Bay Area VC insists that you use their expensive legal counsel?”

Mark Suster, a VC at GRP Partners, has also written and spoken about how he likes to “share” his legal counsel with the startup in which he is investing.  My advice to entrepreneurs is clear: push back hard on this issue and choose your own strong, independent legal counsel – i.e., a law firm that’s going to work hard to protect you and watch your back.

Types of Conflicts of Interest

There are two types of conflicts of interests that need to be addressed when startups are pressured to use an investor’s law firm: ethical and business.

Ethics Rules.  Potential conflicts of interest that arise in the course of a law firm’s delivery of legal services are governed by applicable State Bar ethics rules, with which lawyers are required to comply.  As the Preamble to the ABA Model Rules of Professional Conduct provides in relevant part:

In the nature of law practice . . . conflicting responsibilities are encountered. Virtually all difficult ethical problems arise from conflict between a lawyer’s responsibilities to clients, to the legal system and to the lawyer’s own interest in remaining an ethical person while earning a satisfactory living.  The Rules of Professional Conduct often prescribe terms for resolving such conflicts. Within the framework of these Rules, however, many difficult issues of professional discretion can arise. Such issues must be resolved through the exercise of sensitive professional and moral judgment guided by the basic principles underlying the Rules.  These principles include the lawyer’s obligation zealously to protect and pursue a client’s legitimate interests, within the bounds of the law. . . .

In the event there is a potential conflict of interest between or among clients, most State Bar ethics rules require each client to consent in writing to the attorney’s representation — after full disclosure and consultation.  Indeed, each client must be able to appreciate the situation and have enough information to make a reasonable and informed decision as to whether or not the legal counsel can provide fair representation.  The consent of the client must also be entirely voluntary and not given under any pressure whatsoever, by the attorney or anyone else.

Business Conflicts.  Assuming that law firms are complying with the foregoing ethics rules, there is another issue that needs to be addressed: inherent business conflicts of interest.  This, to me, is the crux of the problem with entrepreneurs using law firms that also represent the investors.

As I noted on Quora, for many of the big Silicon Valley law firms, the venture capital firms are their gravy train and the big law firms need to play ball with them.  This is not to say that any lawyers at these firms are unethical (or that the law firms are not complying with applicable State ethical rules).  Instead, this is about the realities of the economics.

Let’s take a simple example:

Vinny VC meets with Eric Entrepreneur and gets very excited about Eric’s new venture; so excited, in fact, that a few weeks later Vinny presents Eric with a term sheet for a $750K seed financing.  Vinny advises Eric that this is his standard term sheet for seed financing and recommends that he retain Larry Lawyer at the ABC Law Firm to process the documents.  “Larry is great,” Vinny explains, “and we have some lightweight seed documents that we have put together with Larry’s law firm and used with other startups, which will make the process relatively quick and inexpensive.”

“Sounds good,” Eric says, and he meets with Larry Lawyer and signs an engagement letter (with the appropriate waiver of any potential conflicts of interest).  Now here’s the problem:

If Larry Lawyer and his firm are being sent a lot of work from Vinny VC and his firm, Larry is obviously not going to rock the boat and start pushing back on any key issues.  Why?  Because if he does, Vinny will just send his future work to the five other lawyers on his list.  This is not to say anyone is unethical here – this is just common sense.  Vinny wants his deals done quickly and cheaply (and on the forms that Vinny and Larry have created); and Larry wants Vinny to send him lots of legal work.

Accordingly, (i) Larry Lawyer is not going to suggest to Eric Entrepreneur that he talk to other investors and test the market prior to executing the term sheet; (ii) Larry is not going to raise issues such as doing convertible debt in lieu of a preferred stock financing; (iii) Larry is not going to push back hard if the liquidation preference includes some form of participation; (iv) Larry is not going to push hard to cut back on any of the protective provisions; and (v) Larry is not going to suggest that the company doesn’t need investor representation on the Board at this early stage.  In short, Larry is going to play ball because if he doesn’t, Vinny VC will stop calling.

As Antone Johnson, a smart startup lawyer, aptly points out in the comments to the Quora question:

My former firm ([Wilson Sonsini]) gets accused more often than any other of being in the pocket of the VCs, thanks to the “gravy train” alluded to in Scott’s answer.  It does have a vested interest in maintaining strong positive relationships with the VCs that feed it deal after deal.  I never met a lawyer there who wasn’t cognizant of his or her duties to represent the client zealously (meaning the company, not the investor), but I did feel there was a tacit understanding that pissing off the VCs would be a bad career move.

The M&A World

This inherent conflict of interest is not relegated to the VC world.  Indeed, I experienced it first-hand shortly after moving to California — when I got pulled onto an M&A deal at an LA law firm that I had just joined.

The managing partner of the firm was good friends with a middle-market investment banker, who recommended our firm to the client in connection with a complex leveraged buy-out.  I was tapped to quarterback the deal in light of my strong M&A experience in New York.

You have to understand that a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.  Indeed, he only gets paid if the deal closes.  Accordingly, like with the VC’s “recommended” or “preferred” legal counsel, we were supposed to play ball and make sure the deal closed so that the i-banker got paid.

Unfortunately, I’m not very good at playing this kind of ball – particularly when there were significant environmental issues that were not being adequately addressed.  The i-banker wasn’t too happy and, in fact, stuck his finger in my chest and warned:  “We’re going to get this deal done despite you fuck’n lawyers.”  He then vigorously complained to the managing partner that I was blowing-up the deal because I had retained special environmental counsel from my old New York City law firm and we were pushing too hard on the environmental indemnity.

Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for significant environmental problems that it had assumed (by operation of law) as part of the acquisition.

Conclusion

Look – my goal here is not to point fingers and claim that anyone is being unethical or doing something wrong; this is the way business works.  There are inherent conflicts of interest in certain business relationships, and entrepreneurs need to have someone in their corner to point that out to them and to watch their back.  I am proud to play that role.

This week, we present Marc Andreessen, a brilliant entrepreneur and co-founder and general partner of the venture capital firm, Andreessen Horowitz; he is also co-founder and chairman of Ning.  In this interesting, three-minute clip (courtesy of Stanford University’s Entrepreneurship Corner), Marc discusses (i) how to attract top talent to your startup and (ii) the hiring process generally.  I hope you enjoy it.  Many thanks, Scott

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.

Question

My co-founder and I are getting some traction on our new site, and we would like to raise some money from angels to hire a marketing guy and for a couple of other projects.  One issue that has come-up is IP.  We don’t have any IP documents.  All we have are the corporate papers we got from LegalZoom.  Could you give us some guidance about IP issues.  What are some of the mistakes that you’ve seen startups make regarding IP?

Answer

For many start-ups, intellectual property (IP) is their most valuable asset.  Here are the five biggest mistakes I’ve seen startups make regarding their IP:

Mistake #1 – Moonlighting at a Prior Employer.  Startups must ensure that none of the founders’ prior employers have any rights to the venture’s IP because a founder was “moonlighting” while previously employed.  This is a particular concern if the startup is in the same space as a founder’s prior employer.  Even a founder’s use of a prior employer’s computer or telephone in connection with the new venture could be a problem.

Accordingly, each founder should carefully review any agreements with his or her prior employer (e.g., an offer letter/employment agreement, a confidential information and inventions assignment agreement, a stock options agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to the startup’s IP.  Founders should also make sure that when they leave their prior employer they don’t take anything with them (e.g., electronic files, prototypes, customer lists, etc.).

Under California law (regardless of what the agreements or other documents say), an employee owns any “invention” that that he/she developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information, except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.

Mistake #2 – Not Assigning to the Company Any IP Created Pre-Incorporation.  A common mistake startups make is not assigning to the company in writing all of the IP that was created or acquired prior to the company’s incorporation.  Any IP created or acquired by a founder (e.g., code or a domain name) prior to incorporation is typically assigned to the company as part of the founder’s restricted stock purchase agreement or subscription agreement.

Indeed, the IP is usually contributed or assigned by founders as full or partial consideration for the shares of common stock issued to them in a tax-free transaction under Section 351 of the Internal Revenue Code.  A problem arises, however, if one of the founders leaves prior to incorporation and takes his rights to certain IP along with him.

Another problem often arises with respect to IP created pre-incorporation by outside developers or consultants (i.e., non-founders), particularly if the developers or consultants are located outside of the United States.  The IP created often never gets assigned to the company at all either because there was no written agreement or because the company was not a party to the agreement (because it did not exist at the time).

Mistake #3 – Not Executing Confidential Information and Invention Assignment Agreements.  Once the company has been formed, the ownership of the IP should be protected by requiring all of the Company’s founders, employees and consultants to execute confidential information and invention assignment agreements.  Unfortunately, a lot of startups do not require founders, employees or consultants to execute this kind of agreement and run into significant problems with respect to IP ownership.

IP-ownership problems often arise in the context of an angel or VC financing, when the investors are unable to establish a clear chain of title to the startup’s IP as part of their legal due diligence investigation.  Chasing down third parties to execute invention assignment agreements in the context of a financing is not a prudent business approach.

Mistake #4 – Infringing on Another Company’s Trademark.  Another common mistake startups make in connection with their IP is infringing on another company’s trademark.  A trademark is a word, name or symbol etc. that is intended to distinguish a company or product (e.g., Google, Amazon, Zappos); in short, it’s a brand name.  A startup may not use a name or mark that is “confusingly similar” to a name or mark used by another company.

Just because a startup is able to register a certain domain name (or a corporate name in the State of its incorporation) doesn’t mean that it has the right to use a particular trademark.  This is a common misconception.  In order to have the legal right to use a trademark, a company must either (i) be the first to use the mark in interstate commerce or (ii) be the first to register the mark with the U.S. Patent and Trademark Office (USPTO), whichever comes first.

It is therefore very important that startups consult with IP legal counsel early on or, at a bare minimum, do a Web search and a search on the USPTO site to determine whether their use of a particular word or name will possibly infringe on another company’s trademark.  The last thing a startup wants is to start getting some traction and then get nailed with a trademark infringement lawsuit.

Mistake #5 – Not Developing and Implementing an IP Protection Strategy.  Finally, another big mistake that startups make (particularly technology companies) is not developing and implementing an IP protection strategy.  If a startup’s most valuable asset is its IP/technology, it is self-evident that reasonable steps must be taken to protect that asset.

Many entrepreneurs do not understand that IP protection comes in different forms, and one size does not fit all.  For example, “trade secret” protection may be a more effective method to protecting software than a copyright or a patent; or perhaps using all three is an even better option.  The bottom line is that founders of technology companies need to sit down with experienced IP counsel and identify all of their startup’s IP.  They then need to come-up with an effective, reasonably-priced strategy to protect their IP assets.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please ask them in the comments section – or feel free to email our new IP specialist Terry Thomas at tthomas@walkercorporatelaw.com.  Many thanks, Scott

Today, as a bonus to yesterday’s presentation by Keith Rabois, we have Larry Page, co-founder of Google and a brilliant entrepreneur, from a 2002 presentation at Stanford (courtesy of Stanford University’s Entrepreneurship Corner).  In this interesting, 4-minute excerpt, Larry discusses, among other things, the importance of (i) having great people involved with your venture; (ii) becoming an “expert” in your space/domain; (iii) having a “healthy disregard for the impossible”; and (iv) not starting a company because the space is “hot.”  I hope you enjoy it.  Thanks, Scott

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs); it is part 2 of 3 of my posts on choice of entity.  Last week (in part 1), I discussed what’s wrong with an LLC.  This week I address what’s wrong with a sole proprietorship; and next week I’ll address what’s wrong with a partnership.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I founded a web company by myself a while ago and for the last six months I’ve been making some serious coin.  I never formed a corporation or an LLC and was wondering  if you think I should.  I’m not looking for VC funding, and all the guys who work for me are independent contractors.  Why can’t I just remain a sole proprietorship – seems like a waste of money to incorporate at this point.

Answer

The short answer is that a sole proprietorship is great until you get sued.  Indeed, I’m not a big fan of sole proprietorships — and not many good corporate lawyers are.

The advantages of a sole proprietorship are pretty obvious.  First, it’s simple.  There are no legal documents that need to be drafted and no filings with governmental entities (other than perhaps a simple fictitious name or “DBA” certificate if you are doing business under a name other than your own).

Second, it’s inexpensive for the reasons noted above – that is, no legal documents and no filings means no legal fees and no filing costs; and third, there is no “double taxation” – meaning, unlike with a C corporation, the business does not pay income taxes separately.  All income taxes are handled on the owner’s personal tax returns.

As noted above, the biggest disadvantage with a sole proprietorship is that you have unlimited personal liability.  In other words, you as the owner will be held personally liable for all of the business’s activities, including its debts and liabilities.  Why?  Because for legal purposes, there is no distinction between the business and the sole proprietor.

With a web business, there may not be a lot of potential liability exposure compared to, for example, a medical device company or a real estate owner; however, there could be lawsuits relative to IP infringement, privacy regulations, your contractors (in certain circumstances) and other issues.  And if you do get sued, that would mean all of your personal assets (money, home, car, etc.) would be at risk.

Another major disadvantage of a sole proprietorship is that you cannot issue equity (whether it be to a key employee or an investor) because, again, a sole proprietorship is not a separate legal entity.

Finally, there is arguably greater tax audit risk running a business as a sole proprietorship and, accordingly, reflecting the business’s profit or loss on the Schedule C of your federal income tax returns.

Conclusion

The bottom line is that sole proprietorships have limited utility for entrepreneurs and should generally be avoided due to the unlimited personal liability and lack of structure for equity issuances.  Nevertheless, if you still insist on remaining a sole proprietor, you should definitely buy some comprehensive liability insurance from a reputable insurer to protect against lawsuits and other claims.

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question 

My co-founder and I are ready to hire a couple of key employees, and one of our advisors told us we need to set-up a stock option plan and offer the employees some stock options.  What is a stock option and what are some of the issues we need to worry about?  Thanks!

Answer

An employee stock option is a security which grants the employee-recipient the right to buy a certain number of shares of common stock of the company at a future point in time and at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such shares at the time of the grant. 

The issuance of stock options is quite common in startups because it provides employees with an opportunity to benefit directly from the increase in the company’s value – creating extraordinary upside potential; it is appealing from the founders’ perspective as well due to the alignment of interests and the avoidance of any cash outlays. 

Below are five significant issues that you will need to address in connection with the issuance of employee stock options.

1.  Vesting Schedules.  You should establish reasonable vesting schedules in order to incentive the employees to remain with your company and to help grow its business.  The most common schedule vests an equal percentage of options (25%) every year for four years, with a one-year “cliff” (i.e., 25% of the options vesting after 12 months) and then monthly, quarterly or annually vesting thereafter.  (Jeff Bussgang, a General Partner at Flybridge Capital Partners and a smart VC, recently discussed the issue of four-year vesting in his post “Stock vesting: Why is four the magic number?”.)

For senior executives, there is also generally a partial acceleration of vesting upon (i) a triggering event (i.e., “single trigger” acceleration) such as a change of control of the company or a termination without cause; or (ii) more commonly, two triggering events (i.e., “double trigger” acceleration) such as a change of control followed by a termination without cause within 12 months thereafter.

2.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable State commissions; or (ii) there is an applicable exemption from registration.  Fortunately for startups, SEC Rule 701 provides an exemption from registration for any offers and sales of securities (including stock options) made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that they meets certain prescribed conditions.  Most states have similar exemptions, including California, which amended certain securities regulations in July 2007 in order to conform with Rule 701. 

It is indeed imperative that you seek the advice of experienced counsel prior to the issuance of any stock options: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the holders, injunctive relief, fines and penalties, and possible criminal prosecution.

3.  IRC Section 409A.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock options granted as compensation has an exercise price equal to (or greater than) the fair market value (the “FMV”) of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibilities. 

A company can establish a defensible FMV by (i) obtaining an independent appraisal; or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company director or employee), provided certain other conditions are met.  

4.  Size of the Option Pool.  As many entrepreneurs have learned (much to their surprise), venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation — i.e., the total value of the company is divided by the “fully diluted” number of shares outstanding, which is deemed to include not only the number of shares currently reserved for in an employee option pool (assuming there is one), but also any increase in the size (or the establishment) of the pool required by the investors for future issuances. 

The investors typically require a pool of approximately 15-20% of the post-money, fully-diluted capitalization of the company.  Founders are thus substantially diluted by this methodology, and the only way around it is to try to keep the option pool as small as possible (while still attracting and retaining the best possible talent).  When negotiating with investors, entrepreneurs should therefore prepare and present a hiring plan that sizes the pool as small as possible; for example, if the company already has a CEO in place, the option pool could be reasonably reduced to closer to 10% of the post-money capitalization.  (There is an outstanding post “The Option Pool Shuffle” by Nivi of Venture Hacks, which discusses this issue in detail.)

5.  Restricted Stock.  Finally, depending upon the stage/value of your company, you should consider issuing restricted stock to the employees in lieu of stock options for three principal reasons: (i) restricted stock is not subject to Section 409A; (ii) restricted stock is arguably better at motivating employees to think and act like owners (since the employees are actually receiving shares of common stock of the company, albeit subject to vesting); and (iii) the employees will be able to obtain capital gains treatment and the holding period begins upon the date of grant, provided the employee files an election under Section 83(b) of the Internal Revenue Code.

The downside of issuing shares of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election has been filed), the employee is deemed to have income equal to the then fair market value of the shares.  Accordingly, if the shares have a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.  The other downside is compliance with applicable securities laws (as discussed in paragraph #2 above).

Conclusion

I hope the foregoing is helpful.  The takeaway (which may sound a bit self-serving) is that you need to get experienced counsel involved early on to address the foregoing issues.  Indeed, there are generally three documents that must be drafted in connection with the issuance of stock options: (i) a Stock Option Plan, which is the governing document containing the general terms and conditions of the options to be granted; (ii) a Stock Option Agreement to be executed by the company and each optionee, which specifies the individual options granted, the vesting schedule and other employee-specific information (and generally includes the form of Exercise Agreement annexed as an exhibit); and (iii) a Notice of Stock Option Grant to be executed by the company and each optionee, which is a short summary of the material terms of the grant (though this is not a requirement).

Earlier this week, we presented Naval Ravikant.  Today (as a bonus interview for this week), we present Jeff Clavier, the founder and Managing Partner of SoftTech VC, who discusses what he looks for in startups (“it’s people, product, market”) and diligence issues.  I hope you enjoy it.  Thanks, Scott

www.youtube.com/watch?v=_2E2wMvFCtI

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more comprehensive version.  Please give me your input in the comments section.  Many thanks, Scott

Question 

I’m launching a new venture and read your VentureBeat post a few weeks ago about Class F stock.  I’m a little confused because I asked around, and none of my friends who are founders heard of it.  One guy did mention Series FF stock, but I wasn’t sure if that’s the same as Class F?  Please let me know.

Answer 

Yes, it’s definitely confusing — but “Class F” stock and “Series FF” stock are different.

As I previously discussed, Class F stock is a separate class of common stock that was designed in 2009 by The Founder Institute to provide the founders with certain special rights (e.g., super-voting rights) upon incorporation.  The articulated goal is to level the playing field for founders in connection with their negotiations with investors and to protect them from the “atrocities of investors.”   

Series FF stock, on the other hand, is a separate class of preferred (not common) stock that was designed in 2006 by Sean Parker of the Founders Fund to permit founders to cash out a small percentage of their stock prior to a liquidation event. (The “FF” stands for Founders Fund, and it has been used in several Founders Fund deals.)

Indeed, as Barney Pell, the founder of Powerset, noted in the San Francisco Chronicle:

“There is often a tension between venture capitalists and founders. The venture capitalist wants the founders to starve and to have no cash liquidity until the very end. Of course, the founders, unlike the venture capitalists, are putting all of their eggs in one basket…. Sean came up with the idea of allowing founders to sell small amounts of their shares along the way so you can have some life-changing effects and reduce your risk and everyone can be aligned for a home run.”

Here’s how Series FF preferred stock works:

1)      Shares of the Series FF preferred stock are generally issued to the founders upon incorporation or immediately prior to the Series A round. 

2)      The shares are generally identical to shares of common stock, except they are  convertible at the shareholder’s option into shares of the same series of preferred stock issued in a later round (provided that the buyer of the Series FF shares purchases them as part of that round and pays the same price as the preferred stock being issued).

3)      The conversion of the shares of Series FF must be approved by the issuer’s Board of Directors.

As noted above, the significant advantage of issuing Series FF preferred stock is that it allows the founder(s) to take a few chips off the table.  Indeed, for many founders, the opportunity to cash-out is quite appealing, particularly where they have run-up significant credit card debt and/or are interesting in buying a home for their family.  The amount of the cash-out, however, is generally capped to between 10 and 15 percent (depending upon the round of financing). 

The other advantage is that it is a clever way of avoiding issues relating to the increased pricing of options if investors were to buy founders’ common stock, as opposed to preferred stock (converted from the Series FF).

Obviously, the significant disadvantage of issuing Series FF stock is that it may deter investors from investing because investors generally want founders to be “all in” and not pull any money out of the venture.  That being said, there are circumstances where investors permit founders to take some money out, but usually it’s done through a mechanism other than Series FF stock.

Other disadvantages include an added layer of complexity (thus increased legal fees, among other things) and potential litigation from other stockholders (including employees of the company) if the company doesn’t have a successful exit.  Indeed, in the event of litigation, it may be difficult for the founders and/or the Board of Directors to justify having investment funds arguably diverted from the company.

Conclusion

The bottom line is that Series FF stock (like Class F stock) is relatively new and its issuance is not widespread.  Accordingly, for first-time entrepreneurs, it probably makes sense to keep it simple and just issue ordinary shares of common stock.  Nevertheless, I wholeheartedly support any effort to help founders better align their interests with their investors.

I had originally intended to discuss “Series FF” stock in today’s post (as a follow-up to last week’s post regarding “Class F” stock); however, I had several telephone calls in the past few days with respect to the issue of choice of entity for startups and thought it would be helpful to get this post up.

Indeed, one of the most important early decisions an entrepreneur must make in connection with his or her venture is the choice of entity.  There are basically six choices: (1) sole proprietorship, (2) general partnership, (3) limited partnership, (4) C corporation, (5) S corporation or (6) limited liability company.  Below is a discussion of each entity, including a basic description, the advantages and disadvantages, the ideal candidate/business for such entity, the cost to set-up such entity and the most important take-away.

1) Sole Proprietorship

What is It?:  A sole proprietorship is the simplest, most common way of organizing a business.  A sole proprietorship is not a separate legal entity; it is a business owned and run by one person (hence, the term “sole”).  For legal purposes, there is no distinction between the business and the sole proprietor. 

What are the Advantages?:  The significant advantages of utilizing a sole proprietorship include:

• ease of formation – the owner does not have to file any formation documents with governmental agencies (other than perhaps a simple fictitious name or “DBA” certificate if it is doing business under a name other than the owner);
• very inexpensive – since there are no organizational documents, there will be no legal fees for drafting documents and no filing fees (other than for a DBA);
• no double taxation – unlike a C corporation, the business and the owner do not pay income taxes separately; indeed, all income taxes are handled on the owner’s personal tax returns

What are the Disadvantages?:  The significant disadvantages of utilizing a sole proprietorship include:

• unlimited personal liability – this is the biggest problem with a sole proprietorship – i.e., the owner will be held personally liable for all of the business’s activities, including its debts and liabilities
• no equity issuances – a sole proprietorship is by definition owned by one individual; accordingly, the business cannot issue equity (e.g., stock options) to a key employee or to an investor
• no continuity of existence – upon the death or incapacity of the owner, the business ceases to exist  

Ideal for Whom?:  A sole proprietorship is ideal for someone who wants to start a one-person business quickly and inexpensively, and such business will not be seeking outside investment and has limited liability exposure; e.g., a service provider like an accountant would be an ideal candidate – particularly if he or she can buy insurance to protect against any malpractice claims.

How Much Does it Cost to Set-up?:  There is no cost for setting-up a sole proprietorship, other than the cost of filing/publishing a DBA certificate (approximately $50 to $75). 

What’s the Most Important Take-Away?:  The most important take-away is that sole proprietorships have very limited utility for entrepreneurs and should generally be avoided due to the unlimited personal liability and lack of structure for equity issuances.

2) General Partnership

What is It?:  A general partnership is an association of two or more individuals (or entities) to conduct a business as co-owners.    

What are the Advantages?:  The significant advantages of utilizing a general partnership include:

• ease of formation – like a sole proprietorship, there are no formalities required to form a general partnership (though a few states require a simple filing at the county level and a DBA certificate may be required); in fact, a general partnership can be formed without a written agreement between or among the partners – though it would be prudent to have one
• relatively inexpensive – since there are generally no formalities to form a general partnership, it is less expensive than other entities – both initially and on an ongoing basis; however, there will be legal fees associated with the drafting of a partnership agreement
• separate legal entity – in most states, a general partnership is a separate legal entity, with partnership interests that can be issued and transferred, and the partnership can own real estate and other property in the partnership name

What are the Disadvantages?:  The significant disadvantages of utilizing a general partnership include:

• unlimited liability – every partner in a general partnership assumes unlimited liability for the partnership’s debts and liabilities, including any tortious acts committed by a co-partner during the ordinary course of partnership business; obviously, this is a huge potential problem if the partners are individuals – it’s like a sole proprietorship on steroids
• no outside investors – from a practical standpoint, the business will not be able to raise capital from outside investors because investors will not want to be a general partner and subject themselves to unlimited liability
• fiduciary obligations – each partner has a fiduciary obligation to the other partners with respect to all matters affecting the business – which is an extremely high standard requiring undivided loyalty, good faith and fair dealing; this standard has led to a lot of litigation among partners and allegations of conflicts of interest and self-dealing

Ideal for Whom?:  A general partnership is ideal for two or more individuals who wants to start a business quickly and inexpensively – particularly if the business will not be seeking outside investment and has limited liability exposure; e.g., an accounting firm or a law firm would be an ideal candidate.

How Much Does it Cost to Set-up?:  As noted above, a general partnership is relatively inexpensive to set-up.  There are generally no filing fees, other than a DBA certificate (approximately $50 to $75); however, there may be legal fees associated with the drafting of a partnership agreement (approximately $1,000 to $2,500).  

What’s the Most Important Take-Away?:  The most important take-away is that (like sole proprietorships) general partnerships have very limited utility for entrepreneurs and should generally be avoided due to the unlimited personal liability of the owners.

3) Limited Partnership

What is It?:  Like a general partnership, a limited partnership is an association of two or more individuals (or entities) to conduct a business as co-owners; unlike a general partnership, however, there are two kinds of partners: general and limited.  A general partner’s liability is unlimited, and a limited partner’s liability is limited to the amount of his or her investment in the business (hence the term “limited”).  The business is managed by the general partner(s).     

What are the Advantages?:  The significant advantages of utilizing a limited partnership include:

• limited liability – as noted above, the number one advantage of a limited partnership is that the limited partners do not have unlimited liability (such as in a sole proprietorship or a general partnership); again, a limited partner’s liability is limited to the amount of his or her investment, subject to the caveat below (i.e., if a limited partner participates in the control of the business, he or she could be deemed a general partner)
• facilitates outside investors – a limited partnership is a good vehicle for raising capital because the investors become limited partners and thus have limited liability, and the limited partnership interests/units can be easily transferred
• pass-through tax treatment – assuming all of the required formalities have been complied with, a limited partnership’s profits and losses flow directly to the individual limited partners (the entity itself is not taxed, as in a C corporation), which is desirable in certain ventures

What are the Disadvantages?:  The significant disadvantages of utilizing a limited partnership include:

• unlimited liability for general partners – every general partner has unlimited liability; accordingly, in most limited partnerships, the general partners are corporations or limited liability companies in order to shield against personal liability (which creates a complex and expensive structure)
• creature of statute – unlike a general partnership, a limited partnership is a creature of state law; accordingly, a certificate of limited partnership must be filed with the applicable Secretary of State and, in some states (including California), a written limited partnership agreement must be executed
• limited partners may not participate in management – if a limited partner “participates in the control of the business,” he or she could be deemed a general partner and be subject to unlimited personal liability; in certain states, it is unclear what activities constitute “control”

Ideal for Whom?:  Limited partnerships are ideal for businesses that focus on a single or limited-term project (e.g., a real estate project or a film production project) or for so-called “labor-capital” partnerships, where one partner or set of partners (the general partners) do the work and the other partners (the limited partners) provide the capital (e.g., a private equity firm or hedge fund).

How Much Does it Cost to Set-up?:  The costs for setting-up a limited partnership are going to be more than for a partnership because a certificate of limited partnership must be filed with the applicable Secretary of State and a limited partnership agreement must be executed.  Accordingly, there will be filing fees of approximately $250 to $600 and related legal fees for drafting such certificate and the limited partnership agreement of approximately $1,000 to $3,000.  Obviously, there will be additional costs if the general partner is an entity, not an individual. 

What’s the Most Important Take-Away?:  The most important take-away is that limited partnerships have limited utility for most entrepreneurs due to their complexity and the unlimited liability of the general partner(s).

4) C Corporation

What is It?:  A corporation is a separate legal entity created under state law, with a legal existence distinct from its owners.  A C corporation is the most common type of corporation; unlike an S corporation, it is subject to double taxation — which means that first the corporation (as a separate taxable “person”) is taxed on its profits; and second, each of the shareholders are taxed on any dividends distributed to them.  

What are the Advantages?:  The significant advantages of utilizing a C corporation include:

• best shield against personal liability – a C corporation is the most widely-accepted and well-established entity for the protection against personal liability; accordingly, so long as all corporate formalities have been complied with, the shareholders of a C corporation will only be liable for the debts, obligations and liabilities of the corporation up to the amount of the respective investment (regardless of any management participation)
• best entity to attract venture capital – VC funds generally invest only in C corporations (and indeed C corporations formed in Delaware); from a tax perspective, VC funds generally avoid (and may be prohibited under their respective fund documents from) investing in “pass-through” entities such as S corporations or limited liability companies, as discussed below; and from a corporate perspective, Delaware is the most common state of incorporation due to its well-developed case law, management protections and ease of corporate filings (and related administrative issues)
• flexible capital structure – a C corporation offers the simplest and most-flexible capital structure of any entity – e.g., unlike an S corporation, a C corporation may have different classes of stock, and unlike a limited liability company, a C corporation may easily issue stock options to employees and consultants; moreover, such flexibility facilitates capital raising due to the accessibility of a broad range of financial instruments/vehicles, including preferred stock, warrants, convertible notes, subordinated debt, etc.    

What are the Disadvantages?:  The significant disadvantages of utilizing a C corporation include:

• not a pass-through entity – the biggest disadvantage of a C corporation is that it is not a pass-through entity; accordingly, as noted above, it is subject to double-taxation, which means that corporate profits are taxed twice and any losses do not pass through to its shareholders
• onerous formalities and recordkeeping – corporations are subject to onerous formalities under applicable state law, including the filing of a certificate of incorporation, the adoption of bylaws, the election of a Board of Directors, annual meetings of the Board of Directors and shareholders, the maintenance of separate books and records and bank accounts, capitalization requirements, etc.; the failure to adhere to such formalities could result in a court “piercing the corporate veil” and holding the corporation’s shareholders personally liable
• costly set-up and maintenance – as a result of the onerous corporate formalities noted above, the costs for forming and maintaining a corporation are relatively high; e.g., if a corporation is “doing business” in a state other than state of incorporation, it must qualify to do business there (which is like a mini-incorporation) triggering additional costs and taxes 

Ideal for Whom?:  A C corporation is ideal for any business that desires strong protection against personal liability and will be seeking venture capital funding, but does not need pass-through tax treatment prior to such funding (or does not otherwise meet the S corporation requirements below).    

How Much Does it Cost to Set-up?:  A corporation (whether it be a C corporation or an S corporation) is the most expensive entity to set-up due to all of the required paperwork and filings.  Filing fees range from approximately $300 to $900; and legal fees range from $1,000 to $4,000 depending upon the extent of the documentation (e.g., a corporation seeking venture funding should execute founders stock purchase agreements and invention assignment agreements, among other things).  There may also be some accounting fees (approximately $500 to $1,500).

What’s the Most Important Take-Away?:  The most important takeaway is that a C corporation is the best shield against personal liability and should be the first choice of entity for any business that will be seeking venture capital funding.  If venture capital funding is not imminent and the founders will be investing a significant amount of money and would like to personally write-off anticipated losses, an S corporation should be considered as well, as discussed below.    

5) S Corporation

What is It?:  An S corporation is a type of corporation; it is formed under applicable state law just like a C corporation, but an “election” is filed with the Internal Revenue Service.  Accordingly, as noted above, it is a separate legal entity, with a legal existence distinct from its owners.  The name “S corporation” refers to sub-chapter S of the Internal Revenue Code, under which such election is made.  (“C corporations” are named and governed by sub-chapter C of the Internal Revenue Code.)  Unlike a C corporation, an S corporation is a pass-through entity and thus is not subject to double taxation – i.e., profits and losses of the corporation pass through to the individual shareholders.     

What are the Advantages?:  The significant advantages of utilizing an S corporation include:

• effective shield against personal liability – like a C corporation, an S corporation is an effective and well-established entity for the protection against personal liability so long as all corporate formalities have been complied with
• pass-through tax treatment – as noted above, the profits and losses of an S corporation flow directly through the corporate entity to the individual shareholders, which is often desirable; e.g., if founders will be investing a significant amount of cash in a startup venture and VC funding is not imminent, an S corporation may be very appealing because any losses can be written-off on the founders’ respective tax returns up to the amount of their investment (and the amount of certain corporate debt of the S corporation)
• easy to convert to C corporation – as noted above, VC funds generally invest only in C corporations (and are not eligible to invest in S corporations in any event, as discussed below); the conversion from an S corporation to a C corporation, however, is relatively easy — unlike the conversion from an LLC to a C corporation, as discussed below  

What are the Disadvantages?:  The significant disadvantages of utilizing an S corporation include:

• limitation on type and number of shareholders – the biggest disadvantage of an S corporation is that the shareholders may only be (i) individuals who are U.S. citizens or residents, (ii) estates and (iii) certain eligible trusts; and the number of shareholders is capped at 100
• limitation on capital structure – another major disadvantage of utilizing an S corporation is that it may only have one class of stock (except that stock with different voting rights is permitted); accordingly, an S corporation may not issue both common stock and preferred stock – and even the issuance of certain options or convertible notes could invalidate the S corporation election
• onerous formalities and recordkeeping – like C corporations, S corporations are subject to onerous formalities under applicable state law, including the filing of a certificate of incorporation, the adoption of bylaws, the election of a Board of Directors, annual meetings of the Board of Directors and shareholders, the maintenance of separate books and records and bank accounts, capitalization requirements, etc.; the failure to adhere to such formalities could result in a court “piercing the corporate veil” and holding the corporation’s shareholders personally liable

Ideal for Whom?:  An S corporation is ideal for any business that meets the shareholder eligibility requirements and desires strong protection against personal liability and pass-through tax treatment (whether permanently or during the period prior to venture capital funding).     

How Much Does it Cost to Set-up?:  As noted above, a corporation (whether it be a C corporation or S corporation) is the most expensive entity to set-up due to all of the required paperwork and filings.  Filing fees range from approximately $300 to $900; and legal fees range from approximately $1,000 to $4,000 depending upon the extent of the documentation.  There may also be some accounting fees ($500 to $1,500) relative to the S corporation election and other accounting issues.

What’s the Most Important Take-Away?:  The most important takeaway is that an S corporation is an excellent shield against personal liability and should be the choice of entity for any business that will be seeking venture capital funding if such funding is not imminent and the founders would personally like to take advantage of anticipated losses of the corporation.

6) Limited Liability Company

What is It?:  A limited liability company (LLC) is a relatively new entity and can best be described as a hybrid between a C corporation and a general partnership: it protects against personal liability like a C corporation (subject to the caveat discussed below) and it has a general partnership’s flexibility and pass-through tax treatment.  Unlike S corporations, LLC’s have no limitations with respect to the eligibility of its owners (called “members”); accordingly, a corporation or another LLC may be a member of an LLC.  And unlike a limited partnership, the members of an LLC may control the company and participate in its management and still be protected against personal liability.      

What are the Advantages?:  The significant advantages of utilizing a limited liability company include:

• extraordinary flexibility – probably the most appealing aspect of an LLC is its extraordinary flexibility, including with respect to the distribution of cash and other assets, the allocation of income or losses, etc. (all of which is generally reflected in a written operating agreement); indeed, an LLC may be operated like (i) a corporation, with a Board of Managers and officers, (ii) a general partnership, with all members appointed “managers” or (iii) a sole proprietorship, with one member (or outside individual/entity) appointed the manager; an LLC may also elect to be taxed as a C or an S corporation if it so chooses; and, in certain states (like Delaware), an LLC may even limit the fiduciary obligations of its manager(s) 
• effective shield against personal liability – like a C corporation and an S corporation, an LLC is an effective shield against personal liability, subject to one caveat: a few courts have held that a single-member LLC (i.e., an LLC with one owner) is not protected against personal liability; note: single-member LLC’s are tricky and advice from counsel is strongly recommended   
• pass-through tax treatment – as noted above, the other major advantage of an LLC is that profits and losses flow directly through the entity to the individual members (unless, as noted above, the LLC elects otherwise – which is quite rare); as previously discussed, this can be very appealing to avoid the double taxation of profits and to permit the members to write-off certain losses of the company

What are the Disadvantages?:  The significant disadvantages of utilizing an LLC include:

• complexity – the most significant disadvantage of an LLC is its complexity, particularly from a tax and accounting perspective; LLC’s are generally governed by extremely complex partnership tax rules – which trigger pages and pages of tax provisions in the operating agreement and significant ongoing compliance costs
• unattractive to VC’s and other investors – as noted above, VC funds and other institutional investors generally do not invest in pass-through entities; accordingly, if a business is seeking venture capital funding, this would not be a good choice of entity; indeed, converting an LLC to a C corporation is much more difficult and expensive than converting an S corporation to a C corporation
• limitation on capital structure – the other major disadvantage of an LLC is that it is very difficult and expensive (i) to grant options to employees and consultants and/or (ii) to issue other types of securities, such as “preferred” membership interests (like preferred stock in a C corporation), convertible notes, etc.

Ideal for Whom?:  An LLC is ideal for any business that desires (i) protection against personal liability, (ii) pass-through tax treatment and (iii) flexibility with respect to  distributions, allocations and/or management.  Consulting firms and real estate projects are ideal candidates; also, certain private equity and investment funds that previously utilized limited partnerships are adopting the LLC structure.    

How Much Does it Cost to Set-up?:  An LLC can be as expensive as a corporation to set-up due to the legal and tax/accounting fees relative to the drafting of an operating agreement.  Filing fees generally range from approximately $250 to $600; legal fees range from approximately $1,500 to $4,500; and tax/accounting fees could range from approximately $1,000 to $2,500 depending upon the complexity of the operating agreement. 

What’s the Most Important Take-Away?:  The most important takeaway is that LLC’s offer the attractive features of protection against personal liability, pass-through tax treatment and flexibility, but are not the best choice of entity for businesses that will be seeking venture capital funding.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please shoot them to me through the comments section or via email at swalker@walkercorporatelaw.com.  Please note that this post is an abridged version of my recent guest post on Quick Sprout, an outstanding blog written by my friend Neil Patel (who is a highly-successful and very smart entrepreneur).  I strongly recommend that you read all of Neil’s posts.  Many thanks, Scott

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

My two friends and I have been working on a new venture for almost a year.  Our site is in beta and we actually have a few customers (it’s a subscription-based model).  We’ve spoken to a lawyer about incorporating, but we don’t know how to split-up the stock.  Should everyone just get one-third?   

Answer  

That’s a great question.  Before I answer it, however, let me just make a quick point:  When launching a venture, the first rule of thumb is to incorporate as soon as possible when the venture has as little value as possible.  Why?  Because, among other things, you want to be able to issue stock to the founders for a nominal purchase price so that they can share in the increased value of the company (and start the capital gains holding period). 

To the extent the venture’s incorporation is delayed and its value increases due to the meeting of certain milestones, etc., there may be tricky tax issues with respect to the purchase price (or value) of the shares issued to the founders.  Indeed, if the company were ever audited, the IRS may take the position that the shares sold for a nominal purchase price actually had value and deem such value compensation to the founders (particularly if the shares were issued on a date close to a financing date). 

As I have previously discussed, another important reason to incorporate as soon as possible is to protect against personal liability.

Now, with regard to your question whether the equity should be split equally, the short answer is “usually not.”  The splitting of equity is a significant business decision which must be negotiated among the founders based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally among the three of you may sound fair on its face, but it’s usually not the correct decision.

Factors to consider include:

1. Whether any of the founders contributed cash and/or intellectual property to the venture – which would warrant a higher percentage for that founder.
2. Whether any of the founders actually came-up with the idea for the venture – which would warrant a higher percentage for that founder.
3. Whether any of the founders will be working part-time or less than the other founders going forward – which would warrant a lower percentage for that founder.
4. Whether any of the founders put in more time prior to the incorporation (e.g., drafted the business plan) or actually started the venture – which would warrant a higher percentage for that founder.
5. Whether any of the founders will have greater responsibility or will be adding more value going forward than the other founders (e.g., due to domain expertise) – which would warrant a higher percentage for that founder.

The bottom line is that every venture is different, with varied contributions (past and future) by the founders.  It might help to sit down with your co-founders and your lawyer and hash this issue out.  As I discuss in my VentureBeat post regarding founder vesting, you will also need to hash out the vesting schedules, including (i) whether any founders will vest a portion of their stock “up front” and/or (ii) whether a  one-year “cliff” will be imposed on any founders.

Conclusion 

I hope the foregoing is helpful.  There is an interesting post by Frank Demmler entitled “The Founders’ Pie Calculator,” which provides a way to quantify the elements of the decision-making process.

This post is part of a weekly series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott 

Question

I plan on forming a single-member limited liability company (LLC) in California as an umbrella for a number of my different internet-related projects.  One particular project will involve subscription revenue from businesses around the country.  I have heard that some states may not recognize single-member LLC’s.  Are these types of internet businesses suitable for a single-member LLC?  Any other thoughts on single-member LLC’s are appreciated.  Thanks!

Answer

My colleagues and I are asked about entity choices all the time.  As I discussed in my post “Ask the Attorney – Formation Issues (Part I),” if you’re launching a venture, the first thing I recommend is to form an entity that will protect against personal liability.  There are three good choices: a C corporation, an S corporation or an LLC, each of which has its advantages and disadvantages.  A single-member LLC (as opposed to a multiple-member LLC) is a relatively new animal and, until recently, was not recognized in all 50 states.  As discussed below, in theory it has two significant advantages; in reality, probably only one. 

First, like all LLC’s (as mentioned above), a single-member LLC is designed to protect against personal liability.  Accordingly, it should arguably be treated as a separate “person” for legal purposes, and thus the sole member/equityholder should be shielded from any liabilities of the LLC, including debts and lawsuits.

Second, a single-member LLC will be treated as a “disregarded entity” for federal income tax purposes (unless it formally elects to be treated as a corporation), and thus its profit or loss will be reported on an individual member’s Schedule C as if it were a sole proprietorship.  This will save the member time and money in connection with the preparation of income tax returns because the separate LLC entity need not file returns.

The most significant disadvantage of a single-member LLC is the risk that, unlike multiple-member LLC’s, it will not protect against personal liability in the event of a lawsuit or other claim.  Indeed, certain courts have “pierced the veil” of a single-member LLC and have held that it is not a separate entity and thus may not be used to protect the assets of the LLC from the creditors of the member. 

To avoid the “piercing of the veil” issue, I suggest that you do two things: (i) create sufficient legal documentation (including a single-member operating agreement and Manager resolutions, etc.) to reflect that the single-member LLC is indeed a separate entity and has been treated as such; and (ii) if there is significant liability exposure, issue a small equity interest (e.g., 2%) to a close relative – i.e., create a multiple-member LLC — in which case, it will not be a “disregarded entity” for tax purposes.

The other disadvantage to a single-member LLC, according to certain tax practitioners, is the increased audit risk as a result of the individual member utilizing Schedule C as if it were a sole proprietorship (as opposed to separate entity tax returns).

Looking at your particular situation, the good news is that internet-related projects do not likely have significant liability exposure (as opposed to a manufacturing project or the purchase of real estate).  On the other hand, as I previously noted on VentureBeat, if you will be seeking venture capital funding, an LLC (single-member or otherwise) may not be the best choice.

The bottom line is that you need to sit down with a reasonably-priced lawyer and accountant and discuss the foregoing issues and determine what works best for you, based on your business objectives and risk tolerance. 

Conclusion

I hope the foregoing is helpful (and please note that I’m not a tax lawyer – and thus this post should not be construed as tax-related advice in any respect).  If you would like some additional tips regarding launching a venture, you can also check out my post “Launching a Venture: Ten Tips for Entrepreneurs.”