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.” 

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite 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.”  This post is a longer, more-comprehensive version of the VentureBeat post.  

The goal here is two-fold: (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

Two former classmates and I are launching a new venture.  Unfortunately, we don’t have enough money to hire a lawyer.  I found a lot of articles on the web, but I’m still not sure what kind of entity we should form and where.  I also was wondering if there are any other legal issues we should be worrying about? 

Answer  

Thank you for your questions.  This is part II of my answer.  Last week (in part I), I addressed the issues of (i) choice of entity, (ii) place of formation, (iii) equity issuance, (iv) vesting restrictions and (v) prior employment.  Below are five more issues that should be on your radar.  Again, it would be prudent for you to retain a good, reasonably-priced attorney to assist you and watch your back (see our FAQ’s).  If you don’t have the money, some lawyers will defer their fees and/or take equity if you can get them excited about your venture.

1.  Management Issues.  You and your two co-founders should sit down and agree on how the company will be managed — e.g., who will be on the Board of Directors and what position each founder will hold.  Whatever you decide should be reflected in a written agreement (commonly referred to as a stockholders’ agreement or voting agreement), which should also address certain other significant issues, including: (i) rights of first refusal with respect to the sale of any shares by a founder (sometimes addressed in the founders stock purchase agreements); (ii) whether any founders will have veto rights with respect to certain extraordinary company actions (e.g., the sale of the company, borrowing in excess of a certain amount, the issuance of additional shares, etc.); and (iii) whether founders will have so-called “drag-along” rights (i.e., the right to “drag” other stockholders in the event of the sale of a certain percentage of the equity of the company) and/or “tag-along” rights (i.e., the right of a founder to “tag-along” in the event of such a sale).   

The importance of a written agreement to address these issues cannot be over-emphasized.  Indeed, Simeon Simeonov, the founder and CEO of FastIgnite, recently wrote an excellent post on VentureHacks (one of the best websites for startups) entitled “When to fire your cofounders,” in which he discusses the issue of getting rid of an unwanted co-founder.  From a business perspective, it may sound pretty easy; from a legal perspective, it is not — particularly if the founder in question is the CEO (who reports to the Board of Directors).  In short, there must be appropriate documentation in place — such as a stockholders agreement and perhaps an employment letter agreement – otherwise the co-founders may not have the legal authority to terminate another co-founder.

2.  IP Issues.  For many start-ups, particularly technology companies, intellectual property (IP) is their most valuable asset.  Accordingly, certain steps must be taken to ensure that your company owns the IP and protects it.  First, if any technology/IP were developed prior the company’s formation, you must do two things: (i) as noted last week (see #5), confirm that none of the founders’ prior employers has rights to the technology/IP because of prior agreements or applicable law (e.g., because a founder was “moonlighting” while previously employed); and (ii) make sure ownership to the technology/IP is transferred from the applicable founder(s) to the company in writing.  Once the company has been formed, the ownership of the technology/IP should be protected by requiring all of the Company’s employees and consultants to execute confidentiality and invention assignment agreements (as discussed in #4 below).

There are also a number of other IP issues that generally need to be addressed.  Indeed, as startup guru Steve Blank notes in his outstanding post “Someone Stole My Startup Idea – Part 3: The Best Defense is a Good IP Strategy”: “You need a plan for trademarks, copyright, trade secrets, contracts/NDA’s and patents before you get funded.”  Moreover, as Brad Feld (a smart investor) recently tweeted and blogged, you can learn more about IP issues by checking-out the new blog by IP attorney Jill Hubbard Bowman (see, e.g., her post “Ten Smart Reasons to Learn about IP Law”).

3.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an exemption from registration.  The most common exemption used by start-up companies is the so-called “private placement” exemption.  As the term implies, a private placement is a private offering to a small number of purchasers – like a few founders.  The SEC and each of the State securities commissions have their own set of rules regarding private placements, and it is imperative that they be complied with.  Non-compliance could result in serious adverse 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. 

If you are interested in learning more about some of the common mistakes entrepreneurs make relating to securities laws, you can watch my brief video on YouTube: “5 Mistakes Entrepreneurs Make in Raising Capital.”

4.  Employment Issues.  If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) as noted above, a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth the employee’s rights and obligations, including position, compensation, benefits and, most importantly, whether 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 the employee is legally owned by the company. 

Non-competition and non-solicitation provisions may also be included; however, such provisions are generally unenforceable in California other than in the context of the sale of a business (though California courts will generally enforce provisions that prohibit employees from soliciting the company’s employees provided they are reasonable in scope and duration).  Consultants and Board advisors should also be required to execute (i) a written agreement, setting forth their rights and obligations, and (ii) a confidentiality and invention assignment agreement. 

In addition, you need to be very careful about classifying workers as “independent contractors” when in fact they are “employees” in order to avoid paying payroll taxes and otherwise complying with applicable law.  California governmental authorities are particularly concerned about this issue and expressly note on the Department of Industrial Relations website that: “In handling a matter where employment status is an issue, that is, employee or independent contractor, [the the Division of Labor Standards Enforcement] starts with the presumption that the worker is an employee. . . . The most significant factor to be considered is whether the person to whom service is rendered (the employer or principal) has control or the right to control the worker both as to the work done and the manner and means in which it is performed.”  

5.  Stock Option Plan.  Finally, in order to attract and retain key employees (and consultants) and to conserve cash, it would make good business sense for your company to establish a stock option plan or other form of equity compensation plan.  As I mentioned last week, the goal is to issue any equity (including options) as soon as possible when the value of the company is as low as possible; and, as noted above, because options are “securities” their issuance must comply with applicable federal and state securities laws.  The SEC and most State securities commissions (including California) have created an exemption from registration for any offer or sale of securities pursuant to certain plans and contracts relating to compensation.  If you would like to learn more about stock options and some of the tricky issues relating to their issuance, you should check-out my post “Issuing Stock Options: Ten Tips for Entrepreneurs.”

Conclusion

I hope the foregoing is helpful.  If you have any questions about this post or any other legal issues, please ask them in the comments.  Thanks.

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite 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.”  This post is a longer, more-comprehensive version of the VentureBeat post.  

The goal here is two-fold: (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 

Two former classmates and I are launching a new venture.  Unfortunately, we don’t have enough money to hire a lawyer.  I found a lot of articles on the web, but I’m still not sure what kind of entity we should form and where.  I also was wondering if there are any other legal issues we should be worrying about? 

Answer

Thanks for your questions.  Before I answer them, however, let me just say that I think it would be prudent for you to retain a good, reasonably-priced lawyer to assist you and watch your back (see our FAQ’s).  If you don’t have the money, some lawyers will defer their fees and/or take equity (if you can get them excited about your venture). 

1.  Choice of Entity.  You should form an entity that will protect against personal liability.  You have three good choices: a C corporation, an S corporation or a limited liability company.  If you’re going to seek funding, you should form a C corporation because that’s the structure that investors will usually require.  If you’re not going to seek funding (or funding will not be imminent), you may want to form an S corporation or a limited liability company to obtain “pass-through” tax treatment. 

The bottom line is that every situation is different, and that’s why it makes sense to sit down with an experienced lawyer; for example, shareholders in C corporations (as opposed to S corporations or limited liability companies) may be eligible for the “qualified small business stock” capital gains tax break under Internal Revenue Code Section 1202; and losses in C corporations (as opposed to S corporations or limited liability companies) may be deductible up to $50,000/year or $100,000/year on a joint return with respect to “Section 1244 stock.”

2.  Place of Formation.  If you’re going to seek funding, you should form your entity in Delaware regardless of whether the operations are located in California (or any other State).  Why?  Because investors will generally require it due to Delaware’s well-developed case law, its management protections and flexibility, and its ease of corporate filings and related state-law administrative issues.  If the entity has not been formed in Delaware, investors will generally require this issue to be cleaned-up as a condition to closing.  Thus, initially forming the entity in Delaware will demonstrate a certain level of sophistication and credibility.  

If you’re not going to seek funding and you’re forming a corporation which has substantial operations and a majority of its shareholders located in California (a so-called “quasi-California corporation”), you may want to just form it in California for two reasons: (i) California has an unusual law which purports to apply certain significant statutory provisions to quasi-California corporations (even if they are incorporated in Delaware); and (ii) you can save some money by not having to qualify the corporation to “do business” in California (in effect, a mini-incorporation process) – which would be required if the corporation were formed in Delaware. 

3.  Equity Issues.  The venture should be formed and equity should be issued to the founders as soon as possible — i.e., before the company has any significant value.  Clearly, as milestones are met by the company (e.g., the creation of a prototype, the signing-up of customers, etc.), the value of the company will increase and therefore so will the value of the stock, which could trigger significant taxable income to founders being issued equity for services or for a nominal purchase price.  The same principle applies with respect to the issuance of equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible.  In addition, if a founder intends to transfer assets (e.g., technology) to a corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued.      

4.  Vesting Restrictions.  You should impose reasonable vesting restrictions on the equity issued to the founders for two important reasons.  First, it makes good business sense because the equity will presumably be issued not only for the founders’ services or property relating to the conception of the venture, but also for their continuing commitment and efforts.  Indeed, it would be inherently unfair for one of the founders to leave the venture after a few months, but still be permitted to keep all of his/her equity.  Second, if you will be seeking funding, a vesting schedule will usually be required by the investors; and if a reasonable schedule has already been established, it is more likely that the investors will simply keep it in place.  I discuss vesting issues in detail in my posts “Ask the Attorney – Founder Vesting” and “Founder Vesting: Five Tips for Entrepreneurs.”             

5.  Issues re Prior Employment.  I’m not sure if this applies to you (i.e., if you and your co-founders are currently employed), but you could run into problems if your new venture is in the same space as any founder’s prior employer.  Each founder must review the agreements with his or her prior employer (e.g., offer letter/employment agreement, non-disclosure and inventions assignment agreement, stock options agreement, etc.) to determine if there are any provisions that may inhibit the new venture.  Employee handbooks and any other relevant documents should also be reviewed.  Provisions to focus on include (i) confidentiality provisions, (ii) non-compete provisions (which are generally unenforceable in California), (iii) provisions regarding the non-solicitation of customers, vendors or employees and (iv) provisions regarding the assignment of inventions. 

If the new venture is a technology company, particular attention must be paid to the creation of the intellectual property.  Under California law, an employee owns any invention that the employee 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. 

Conclusion

I hope the foregoing is helpful.  I will provide five more issues to watch-out for in part 2 of this post.  

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite 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.”   

The goal here is two-fold: (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). 

Question 

My two friends and I are launching a new venture, and we have agreed to split the stock ownership equally.  The problem is that I’m not sure how committed they both are.  What happens if one of them leaves in a few months?  Does he still get to keep all of his stock?

Answer 

This is a common issue among founders.  I strongly suggest that you create what is called a “vesting schedule” upon the company’s incorporation, which would require stock ownership to vest over time.  Indeed, it is customary to impose reasonable vesting restrictions on founders’ stock because the stock has generally been issued not only for the founders’ services and/or property (e.g., software) relating to the conception of the venture, but also for their continuing commitment and efforts.  As your question implies, it would be inherently unfair for one of the founders to quit the venture after a few months (or weeks), but still be permitted to keep all of his stock.

The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis.  Sometimes, however, it may be appropriate to impose a one-year “cliff” (i.e., the founders would not get their first 25% unless they have remained with the company for 12 months) – particularly where the founders don’t know each other or don’t have a history of working together.  Another possibility is to vest a portion of the stock “up front” (i.e., one or more founders would receive a certain percentage immediately) – usually as a result of their contributions to the venture prior to the issuance of the stock or date of incorporation.  Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to sign 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. 

In addition, a vesting schedule will usually be required by the investors in connection with the first professional (“Series A”) round of financing.  Accordingly, it would be prudent for the founders to impose a reasonable vesting schedule upon incorporation for a second reason: if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.  

If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule, which means that vesting will, in effect, force the founders to “earn” stock they think they already own.  This may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up. 

Finally, there are often issues relating to the acceleration of vesting that need to be addressed among the founders, including (i) what happens if the company is sold and (ii) what happens if a founder is terminated “without cause.”

Conclusion

If you would like to learn more about founder vesting, you can check out my post Founder Vesting: Five Tips for Entrepreneurs; and if you have any questions that you would like answered with respect to any legal issues, please send them to me through the comments section of this post.

1.  Issue Options ASAP.  Stock options give key employees the opportunity to benefit from the increase in the company’s value by granting them the right to buy stock at a future point in time at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such stock at the time of the grant.  The venture should thus be incorporated and, to the extent applicable, stock options should be issued to key employees as soon as possible.  Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the creation of a prototype, etc.), the value of the company will increase and thus so will the value of the underlying stock of the option.  Indeed, like the issuance of shares of common stock to the founders (who rarely receive options), the issuance of stock options to key employees should be done as soon as possible, when the value of the company is as low as possible. 

2.  Comply with Applicable Federal and State Securities Laws.  As discussed in my post on launching a venture (see #6 here), 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.  Rule 701, adopted pursuant to Section 3(b) of the Securities Act of 1933, provides an exemption from registration for any offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that it meets certain prescribed conditions.  Most states have similar exemptions, including California, which amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 (effective as of July 9, 2007) in order to conform with Rule 701.  This may sound a bit self-serving, but it is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities, including stock options: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

3.  Establish Reasonable Vesting Schedules.  Entrepreneurs should establish reasonable vesting schedules with respect to the stock options issued to employees in order to incentivize the employees to remain with the company and to help grow the 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 – though monthly may be preferable in order to deter an employee who has decided to leave the company from staying on board for his next tranche.  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.    

4.  Make Sure All of the Paperwork Is in Order.  Three documents must generally be drafted in connection with the issuance of stock options: (i) a Stock Option Plan, which is the governing document containing the 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 such Notice is not a requirement).  In addition, the Board of Directors of the Company (the “Board”) and the stockholders of the Company must approve the adoption of the Stock Option Plan; and the Board or a committee thereof must also approve each individual grant of options, including a determination of the fair market of the underlying stock (as discussed in paragraph 6 below).

5.  Allocate Reasonable Percentages to Key Employees.  The respective number of stock options (i.e., percentages) that should be allocated to key employees of the company generally depends upon the stage of the company.  A post-Series-A-round company would generally allocate stock options in the following range (note: the number in parentheses is the average equity granted at the time of hire based on the results from a 2008 survey published by CompStudy): (i) CEO – 5% to 10% (avg. of 5.40%); (ii) COO – 2% to 4% (avg. of 2.58%); (iii) CTO – 2% to 4% (avg. of 1.19%); (iv) CFO – 1% to 2% (avg. of 1.01%); (v) Head of Engineering – .5% to 1.5% (avg. of 1.32%); and (vi) Director – .4% to 1% (no avg. available).  As noted in paragraph 7 below, the entrepreneur should try to keep the option pool as small as possible (while still attracting and retaining the best possible talent) in order to avoid substantial dilution.             

6.  Make Sure the Exercise Price Is the FMV of the Underlying Stock.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock option 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.  The 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 employee), provided certain other conditions are met.      

7.  Make the Option Pool As Small As Possible to Avoid Substantial Dilution.  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, as discussed in an excellent post by Venture Hacks, is to try to keep the option pool as small as possible (while still attracting and retaining the best possible talent).  When negotiating with the 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.

8.  Incentive Stock Options May Only Be Issued to Employees.  There are two types of stock options: (i) non-qualified stock options (“NSOs”) and (ii) incentive stock options (“ISOs”).  The key difference between NSOs and ISOs relates to the ways they are taxed: (i) holders of NSOs recognize ordinary income upon the exercise of their options (regardless of whether the underlying stock is immediately sold); and (ii) holders of ISOs do not recognize any taxable income until the underlying stock is sold (though Alternative Minimum Tax liability may be triggered upon the exercise of the options) and are granted capital-gains treatment if the shares acquired upon exercise of the options are held for more than one year after the exercise date and are not sold prior to the two-year anniversary of the options’ grant date (provided certain other prescribed conditions are met).  ISOs are less common than NSOs (due to the accounting treatment and other factors) and may only be issued to employees; NSOs may be issued to employees, directors, consultants and advisors. 

9.  Be Careful When Terminating At-Will Employees Who Hold Options.  There are a number of potential claims at-will employees could assert relative to their stock options in the event that they are terminated without cause, including a claim for breach of the implied covenant of good faith and fair dealing.  Accordingly, employers must exercise care when terminating employees who hold stock options, particularly if such termination occurs close to a vesting date.  Indeed, it would be prudent to include in the employee’s stock option agreement specific language that: (i) such employee is not entitled to any pro rata vesting upon termination for any reason, with or without cause; and (ii) such employee may be terminated at any time prior to a particular vesting date, in which event he will lose all rights to unvested options.  Obviously, each termination must be analyzed on a case-by-case basis; however, it is imperative that the termination be made for a legitimate, non-discriminatory reason.

10.  Consider Issuing Restricted Stock in Lieu of Options.  For early-stage companies, the issuance of restricted stock to key employees may be a good alternative to stock options for three principal reasons: (i) restricted stock is not subject to Section 409A (see paragraph 7 above); (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 thus better aligns the interests of the team; 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.  (As noted in paragraph 8 above, optionholders will only be able obtain capital gains treatment if they were issued ISOs and then meet certain prescribed conditions.)  The downside 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 stock.  Accordingly, if the stock has a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.  Restricted stock issuances are thus not appealing unless the current value of the stock is so low that the immediate tax impact is nominal (e.g., immediately following the company’s incorporation).

www.youtube.com/watch?v=NtSeN0wA598

Mistake #1 – Playing Securities Lawyer 

A company may not offer or sell its securities unless (1) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.  Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

Mistake #2 – Selling Stock to Friends and Family Who Are Not “Accredited Investors”

The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 of Regulation D.  There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D, (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” – though it still may be prudent to furnish to investors a private placement memorandum (or at least a summary and a set of risk factors).  There are eight categories of investors under the definition of “accredited investor” – the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.  Indeed, if a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.    

Mistake #3 – Advertising or Soliciting Investors 

Subject to certain limited exceptions, Regulation D of the Securities Act of 1933 prohibits issuers from “general advertising” or “general solicitation” in connection with a private placement.  These terms are not defined under the Securities Act, but have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or similar media or broadcast over television or radio or on a website; “general solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor.  That’s the test: there must be a “substantial and pre-existing relationship” -- and there are a number of SEC no-action letters which discuss what that means; simply put, it means there must a business relationship that is in place prior to the offer sufficient for the issuer to determine that the offeree would be a suitable investor. 

Mistake #4 – Using an Unregistered Finder to Sell Securities 

Entrepreneurs often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus will be subject to serious adverse consequences (as noted in paragraph #1 above), including giving the securityholders the right of rescission. 

Two caveats: (1) In 2004, California enacted a law specifically addressing this issue, which provides for (i) an express right of rescission to any investor who purchases a security from a person or entity that acted as a “broker-dealer” but was not registered; and (ii) the right of the purchaser to sue the unregistered seller for money damages.  (2) In 2008, the SEC adopted a new Form D (which, as noted above, is the official notice of a private placement under Regulation D), which must include the identities of all brokers and/or finders engaged in the offering of securities of the issuer.  This will obviously result in increased scrutiny of finders that are not registered as broker-dealers.

Mistake #5 – Selling Preferred Stock to Angel Investors  

Unless a start-up is raising at least $750K for an angel financing, it may not make sense from a practical standpoint for it to issue preferred stock.  Indeed, preferred stock financing are complicated, time-consuming and expensive – plus the company would need to be valued, which could be extremely dilutive to the founders.  Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, which keeps the financing simple and inexpensive, defers the valuation until the Series A round and gives the investors a discount on the conversion price (or a warrant) as a sweetener.  Needless to say, if superstar angels are interested in investing in your company, but insist on preferred stock, bite the bullet and take the money; great partners trump all rules.

1.  Protect Yourself from Personal Liability.  The entrepreneur’s first step in connection with launching a start-up should be to form an organization that will protect against personal liability.  As discussed below, a Delaware C-corporation is the structure that VC investors will generally require; however, if a financing is not imminent, it may be prudent for the entrepreneur to form an S-corporation or a limited liability company to obtain “pass-through” tax treatment (and then convert the entity to a C-corporation down the road, if necessary) to take advantage of the company’s initial losses, if applicable.  The bottom line is that the entrepreneur should seek the advice of counsel in connection with the formation of any business organization, including the advice of tax counsel (e.g., shareholders in S-corporations — as opposed to C-corporations — are not eligible for the “qualified small business stock” capital gains tax break; and losses in C-corporations may be deductible up to $50,000/yr. or $100,000/yr. on a joint return with respect to “Section 1244 stock”).

2.  Form a Delaware C-Corporation.  VC funds generally invest in Delaware C-corporations.  From a tax perspective, funds generally avoid (and may be prohibited under their respective fund documents from) investing in pass-through entities.  From a corporate perspective, Delaware is the most common state of incorporation (regardless of where the operations are located) due to its well-developed case law, management protections and flexibility, and ease of corporate filings and related state-law administrative issues.  Despite Delaware’s appeal, however, if the business has substantial operations and a majority of its shareholders located in California (a so-called “quasi-California corporation”), it may be simpler to form the corporation in California (i) due to the uncertainty regarding Section 2115 of the California Corporations Code, which purports to apply certain significant statutory provisions to quasi-California corporations (even if they are incorporated in Delaware); and (ii) the state-law requirement that a quasi-California corporation (or a corporation that otherwise has sufficient contacts with California) that is incorporated in Delaware or any other state must qualify to “do business” in California (in effect, a mini-incorporation process).  Again, the entrepreneur should seek the advice of counsel with respect to choosing the state of incorporation. 

3.  Incorporate and Issue Stock ASAP.  The venture should be incorporated and stock should be issued to the founders as soon as possible — i.e., before the company has any significant value.  Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the creation of a prototype, the signing-up of customers, etc.), the value of the company will increase and therefore so will the purchase price of the stock (which could trigger significant taxable income to those founders receiving stock in exchange for past or future services).  Moreover, if a founder intends to transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued.  Indeed, the same principle applies with respect to the issuance of stock options/equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible.           

4.  Impose Reasonable Vesting Restrictions.  As discussed in my earlier post, “Founder Vesting: Five Tips for Entrepreneurs,” the founders should impose a reasonable vesting schedule on the stock issued to them at the time of incorporation for two important reasons: (i) a vesting schedule will be required by the VC investors, and if a reasonable schedule has already been established, it is more likely that the investors will simply keep it in place; and (ii) it makes good business sense because, in most cases, the stock has been issued not only for services or property relating to the conception of the venture, but also for the founders’ continuing commitment and efforts — indeed, it would be inherently unfair for one of the founders to leave the venture after a few weeks/months, but still be permitted to keep all of his/her stock.  The most common schedule for founders vests an equal percentage of options (25%) every year for four years on a monthly basis.  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 (subject to certain exceptions).  As discussed in detail in paragraph #3 here, it is generally advisable for any founders receiving shares subject to vesting to make a Section 83(b) election with the Internal Revenue Service, which will prevent the founder from recognizing income at the time the stock vests.  Such an election must be filed within 30 days after the purchase date of the restricted stock.       

5.  Execute a Stockholders’ Agreement.  If there are two or more founders, it may be prudent to execute a stockholders’ agreement in order to address certain significant issues between or among the founders, including (i) voting rights and obligations, (ii) veto rights and (iii) rights of first refusal (if not addressed in Restricted Stock Purchase Agreements, as discussed in paragraph 4 above).  In the event there are only two stockholders with an equal number of shares, it may also be prudent to include certain so-called “deadlock” provisions in the stockholders’ agreement (such as a “Russian roulette” provision, a “Texan shoot-out” or a “Dutch auction”).  Needless to say, the closer the corporation is to a VC financing, the less importance a shareholders’ agreement holds because it will be superseded by the applicable venture documents.

6.  Comply with Applicable Federal and State Securities Laws.  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 the start-up there are certain prescribed transaction exemptions which may be applicable, including the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933, as amended (the “1933 Act”), and Regulation D promulgated thereunder (as well as Rule 701 discussed in paragraph 9 below).  It is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  The rule of thumb in this area is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996.  (Note: anti-fraud rules are still applicable under Rule 506.)

7.  Protect Your IP.  For many start-ups, intellectual property (or “IP”), such as copyrights, 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 below, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements.  It may be prudent for entrepreneurs to retain separate IP counsel to address some of the foregoing issues, particularly where IP protection is significant to the business model. 

8.  Address Employment Issues.  If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter agreement 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.  (Note: under California Labor Code Section 2870, an employer may not require an employee to assign rights in an invention that the employee 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.)  Non-competition provisions may also be appropriate; 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 (i.e., not overbroad) in scope and duration.  Moreover, it would be prudent for the company to create an employment manual setting forth the company’s policies (including with respect to equal opportunity/non-discrimination and sexual harassment) and establishing the parameters of the employer-employee relationship. 

9.  Establish a Stock Option/Equity Compensation Plan.  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 or other form of equity compensation plan.  Again, the goal is to do it as soon as possible when the value of the company is as low as possible.  As noted above, any offer or sale of securities must comply with applicable federal and state securities laws.  Rule 701 promulgated under the 1933 Act creates an exemption from registration for any offer or sale of securities pursuant to certain compensatory benefit plans and contracts relating to compensation, provided that it meets certain prescribed conditions.  Most states have similar exemptions, including California, which recently amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 to significantly liberalize the requirements under California law to conform with Rule 701.  Moreover, under Section 409A of the Internal Revenue Code, the company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value 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 responsibility.  The company can establish a defensible fair market value 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 employee), provided certain other conditions are met.  (Note: restricted stock is not subject to Section 409A.)  Again, the entrepreneur should seek the advice of counsel before issuing stock options or other equity.

10.  Pay To Play.  Based on the foregoing, it is self-evident that now is not the time for the entrepreneur to try to save money by doing legal work on his own or by relying on printed forms from a web service like LegalZoom (see FAQ’s).  Indeed, there are a number of significant legal issues that must be addressed to protect the entrepreneur and his venture.  Moreover, VC firms and other outside investors will be doing extensive due diligence on the company prior to making an investment and, accordingly, it is imperative that the entrepreneur demonstrate a certain level of credibility and sophistication.  Remember: “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.”  The Silicon Valley Edge, edited by C-M Lee, et al. (Stanford University Press 2000), p. 328 (quote by C. Johnson, Esq.).

1.  Impose Reasonable Vesting Restrictions Upon Incorporation to Address  Issues between or among the Founders.  If there are two or more founders, they should impose reasonable vesting restrictions on the stock issued to them at the time of incorporation because, in most cases, the stock has been issued not only for their services or property (e.g., technology) relating to the conception of the venture, but also for their continuing commitment and efforts.  Indeed, it would be inherently unfair for one of the founders to quit the venture after a few weeks or months, but still be permitted to keep all of his stock.  The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis; however, it may be appropriate (depending upon the founders’ respective contributions and relationship) (i) to impose a one-year “cliff” and/0r (ii) to vest a portion of the stock “up front.”  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.  

2.  Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues with the Series A Investors.  A vesting schedule will usually be required by the investors in connection with a Series A financing.  Accordingly, it would be prudent for the founders to impose a reasonable vesting schedule upon incorporation for a second reason: if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.  If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule, which means that vesting will, in effect, force the founders to “earn” stock they think they already own.  This may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up.  If a founder has strong leverage, the best deal he can likely negotiate with respect to a vesting schedule is the following: approximately 25% of his stock deemed vested at the closing of the Series A financing and the balance of the stock vesting on a monthly basis over the next three years. 

3.  Make an “83(b) Election”.  Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) 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 was purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.  Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting — which could create a situation where the founder has significant tax liability, but no cash to pay it.  It is therefore advisable (subject to consultation with tax counsel) for any founders receiving restricted stock to make an 83(b) election with the Internal Revenue Service (the “IRS”).  Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).  Finally, Section 83 may also apply in situations where the founder has purchased or been granted stock that is fully-vested, but then later agrees to the imposition of vesting restrictions. 

4.  Push for Acceleration Upon a Change of Control.  As Brad Feld aptly points out: “Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to ‘get all their stock in a transaction – hey, we earned it!’ and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price.”  From the potential acquiror’s perspective, full acceleration is generally not a good thing because the founders have no incentive (i.e., “skin in the game”) going forward, and the acquiror will thus have to come out-of-pocket to re-incentive them.  Accordingly, a common solution is for the founders to push for either (i) partial acceleration upon a change of control (i.e., some percentage of vesting is accelerated, with the balance continuing to vest perhaps at an accelerated rate provided the founder remains employed by the acquiror); or (ii) as Chris Dixon suggests, full vesting upon a change of control after a transition period (e.g., after the founder remains employed by the acquiror for one year).  The investors will likely push back and will generally only agree to a partial acceleration in the event of a “double trigger” (e.g., a change of control and a termination without cause within one year).  Founders should push back on this and require full acceleration in the event of a double-trigger.  Bottom line: this issue must be resolved in the context of the negotiation of all of the significant issues and will obviously depend upon the parties’ respective bargaining power. 

5.  Discuss Partial Acceleration Upon a Termination Without Cause.  Another potential hot button is what happens if a founder is terminated without “cause” or he quits for “good reason” (e.g., his job responsibilities have been substantially diminished).  This is a tricky issue.  Obviously, from an individual  founder’s perspective, there should be full acceleration of all of his unvested shares if he is terminated without cause or he quits for good reason because he has, in effect, been denied the opportunity to “earn” his stock.  From the investors’ and the other founders’ perspective, full acceleration is a problem for two significant reasons: (i) startups need the flexibility to make personnel changes if things aren’t working out, and it is difficult to establish “cause” or negate “good reason” from a legal perspective (and startups certainly do not want to expend time and money litigating this issue); and (ii) a replacement will likely need to be hired and additional stock/options will thus need to be issued.  A compromise position, which may be amenable to all of the parties, is a partial acceleration akin to the amount of severance (e.g., six-months’ acceleration).