“Ask the Attorney” – Formation Issues (Part I)

by Scott Edward Walker on January 27th, 2010

Introduction

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.  Indeed, if you’re a tech startup, forming a C corporation is standard.

Notwithstanding the foregoing, you should discuss the different entity choices with an experienced lawyer to understand the significant issues, including tax issues.  For example, stockholders 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.”  On the other hand, S corporations and limited liability companies are “pass-through” entities for tax purposes.

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 Board and management protections, its special court system 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.

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.  Cheers, Scott

 

 

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11 Responses to ““Ask the Attorney” – Formation Issues (Part I)”

  1. danielprater says:

    A group of about three professionals and I will be soon incorporating, most likely as a Delaware C corp. I have a couple quick questions:

    First, how do we determine the share value of the money that each partner contributes? Some of us will contribute no money, and likely others will contribute the majority of our initial capital.

    Second, under IRS Section 351, are there provisions allowing the transfer of personal IRA retirement fund money to the company, avoiding income taxation and early withdrawal penalties, etc?

    This is one of my favorite blogs. Thank you for posting this most exceptional information.

    DP

  2. I will be out of the office today (Thurs, 1/28) attending a conference and thus may not be able to respond to your email for a few hours. If you need immediate assistance, please contact my assistant Karin at . Thanks.

  3. Thanks Dan. Both questions require input from tax counsel/accountant.
    If you need a couple of recommendations, pls send me an email at
    .

  4. Very informative. At the risk of seeming lazy, do you have any post relating to members managed of officer managed structures? We are opting for member managed while it's just three of us and some contractors, but foresee the day when we need to setup a reasonable corporate structure. Thanks!

  5. Hey Tristan – Sorry, I haven't done a post yet relating to member/officer managed LLC's; however, I typically recommend to my clients that they set-up the LLC management structure akin to a corporate structure — with a Management Committee/Board of Managers and designated officers (CEO, CFO & Sec). Indeed, all of the management issues are addressed in an Operating Agreement (similar to Bylaws and Board resolutions in a corporation). Thanks, Scott

  6. Yes, I think this is most common. Personally I always have some qualms about being forced into a standard hierarchy which will color early collaboration, but in terms of risk management it is likely the safest way to go. Thanks again, Tristan

  7. Very informative. At the risk of seeming lazy, do you have any post relating to members managed of officer managed structures? We are opting for member managed while it's just three of us and some contractors, but foresee the day when we need to setup a reasonable corporate structure. Thanks!

  8. Hey Tristan – Sorry, I haven't done a post yet relating to member/officer managed LLC's; however, I typically recommend to my clients that they set-up the LLC management structure akin to a corporate structure — with a Management Committee/Board of Managers and designated officers (CEO, CFO & Sec). Indeed, all of the management issues are addressed in an Operating Agreement (similar to Bylaws and Board resolutions in a corporation). Thanks, Scott

  9. Yes, I think this is most common. Personally I always have some qualms about being forced into a standard hierarchy which will color early collaboration, but in terms of risk management it is likely the safest way to go. Thanks again, Tristan