Company Formation – Startup Checklist

Startup Checklist

Here is a checklist to help keep track of many of the important matters that must be considered and addressed in connection with starting up and beginning to operate a new business.  Note that this is a generic starting point and you will need to work with your team, counsel, and advisors to complete the picture based upon the specific needs of your business.

 Preliminary Considerations – Making a Clean Break

•  Contractual Restrictions.   Review all existing agreements with current employer for potentially restrictive noncompetition, assignment of inventions, nonsolicitation and confidentiality provisions.
• Beware of Pre-Termination Development Efforts.   Beware of potential issues involved with beginning to develop a new business prior to leaving your current employer.  Ownership of developed ideas and assets may become entangled with existing employer.
•  Handbooks/Policies.  Review employment handbooks and policy manuals, and if you are at a University as a student or professor, consider University IP policies to determine if there are any restrictions on starting a new business or ownership rights that need to be addressed prior to or in connection with starting the new business.

Founders Matters

•  Identify Founders.   Identify the key players who will commit to the success of the business, provide valuable skills and intellectual capital, and are prepared to devote significant time and effort to the new enterprise. 
• Confirm No “Lost Founders”.  Consider whether there are any individuals who may have contributed in some meaningful, even if limited, way to the business and who may, even if unlikely, have some claim to the business idea or the initial intellectual property developed.  If necessary, clear potential conflicts and claims with such individuals.    
• Address Founder Restrictions.  Determine whether any founder is subject to restrictions that need to be addressed, such as a founder being subject to an applicable noncompete, nonsolicit or confidentiality agreement, a founder being subject to policies (such as university IP policies) that may complicate ownership of intellectual property developed by such founder, a founder needing to make a clean break from his/her current employer, or a founder not able to devote the same degree of effort as the other founders due to other professional or personal obligations.  
• Address Founder Noncompete Issues.   Discuss Founders’ being subject to noncompetes to benefit the new startup.
• Divide the Pie; Vesting.  Resolve among founders how to “fairly” divide the founders equity amongst the group.   Discuss need for and terms of vesting of founders shares.
• Early Issuance of Equity:  Consider applicable tax aspects of issuing stock to founders, including importance of purchasing stock early to support lower price for founders stock.

General Organizational/Corporate Matters

•  Choose the Entity.  Consider entity formation options (mainly, C Corp, S Corp, LLC), and evaluate related liability, tax, employment, venture financing, and other matters related to choice of entity. 
• Name the Entity.   Consider names for the business and potential differences between corporate name, domain names and trademark rights, and search state entity databases, domain name registrars and, if applicable, USPTO site to determine availability of desired name.
• Prepare/File Organizational Documents.   Work with counsel to prepare, review and execute organizational documents that reflect agreed upon capital structure, governance and related formation matters.   
• Prepare/Execute Founders Agreements.  Work with counsel to prepare, review and execute agreements with the Founders reflecting governance/control matters, vesting matters, and noncompete and confidentiality matters.
• Stock Vesting Matters.  If vesting of founders’ stock is applicable, work with counsel to prepare and file 83(b) election. 
• EIN Number: Obtain Federal Tax Employer Identification Number for entity.  EINs are needed for, among other things, opening bank accounts and making payroll.   EIN can be applied for online at www.irs.gov.
• Open Bank Accounts:  Open corporate bank account after company is formed and EIN number is obtained to deposit payments for founders stock and to establish financial separation between founders and company.
• Foreign Qualification: Discuss with counsel issues relating to operation in jurisdictions outside of state of formation, including state and local taxes, business regulatory environment and foreign qualification and related fees. If necessary, apply for foreign qualification is other states at formation or at appropriate time thereafter.
• Local Requirements:  Evaluate need for local permits depending on nature of business being conducted.  If necessary, apply for and obtain local permits.

 Corporate Records

•  Maintenance Records:  Develop system for maintaining complete, accurate and accessible corporate records, including board and stockholder records and other business records.  
• Forms of Consents/Minutes:  Work with counsel to develop forms of minutes and consents evidencing Board and stockholder actions.
• Board Actions:  On an ongoing basis, Board should be consulted with, and will be required to approve, a broad range of corporate and other material matters.  Discuss with counsel scope of Board authority and responsibility, and the importance and manner of documenting Board actions.
• Stockholder Actions:  On an ongoing basis, startup’s stockholders will be required to approve certain material corporate matters.  Discuss with counsel scope of stockholder authority and typical requirements for stockholder approval, and the importance and manner of documenting stockholder actions.
• Capitalization Table:  Develop and maintain a complete and accurate capitalization table. 

Seed Financing Matters

•  Seed Financing Generally:  Discuss with counsel manner/structures for obtaining and securing seed financing.  
• Don’t Do It Alone:  Securities laws are implicated even in very small seed financings.   Avoid selling (or promising to sell) securities prior to discussing regulatory requirements and recommended process  with counsel.

 Employment and Consultant Matters

•  Employment Matters Generally: Consider importance of employment letters and business protection agreements, risks relating to deferring salaries of employees in advance of a funding round, importance of at will arrangements and avoiding agreeing to severance provisions with employees, and proper classification of employees as exempt/nonexempt.
• Form Employment Letter/Business Protection Agreement:  Develop with counsel forms of employment letters and Business Protection Agreements to be used in connection with hiring employees.
• Consultant Matters Generally:  Discuss with counsel importance of entering into written consulting agreements to secure ownership of developments created by consultants, and proper distinctions between consultants and employees. 
• Form Consulting Agreement:  Develop with counsel a form of consulting agreement to be used in connection with engaging consultants.
• Payroll Matters: Establish good payroll practices, including ensuring that each employee and consultant completes and executes necessary INS and IRS forms and that startup properly withholds taxes and makes necessary tax filings related to payments made to employees and consultants.
• Workers Compensation Insurance:  Discuss with counsel need to obtain workers compensation and unemployment insurance and the requirement to make appropriate state filings related thereto.
• Posting Requirements:  Federal and state laws require employers to hang posters that provide information to employees about applicable state laws (e.g., FMLA, OSHA).  See Department of Labor, “Poster Page: Workplace Poster Requirements for Small Businesses and Other Employees,” http://www.dol.gov/osbp/sbrefa/poster/matrix.htm.
• Record Retention:  Adopt and implement record retention policies and procedures related to employees.
• Employee Handbook:  Adopt employee handbook and related policies (hiring, vacation, leaves, harassment, electronic communications, substance abuse, etc) and procedures related to same.
• Foreign Employees:  Discuss possible filing and other requirements prior to hiring any foreign nationals.

 Option Plan and Benefits

•  Option Plan:   Consider establishing an Option Plan upon formation and, if a Plan is to be established, the size, terms, rules and implementation of such a Plan.    Work with counsel to prepare Option Plan and related form Option Agreements.
• Option Grants:  Discuss with counsel procedure for granting options, including necessity to obtain Board consent, FMV requirements, and specificity of vesting and other key terms. 
• 409A Valuations:  Discuss with counsel necessity of issuing options at FMV and the appropriate procedures for compliance with 409A, including when it is preferable to obtain an independent valuation of the startup’s common stock
• Benefit Plans:  Consider timing and process for properly adopting and implementing medical, retirement and similar plans and programs for the benefit of startup’s employees, including the need to obtain Board approval of such plans, the need to make certain disclosures to employees, and the need to make certain IRS and other filings related to such plans and programs. 

 Intellectual Property Matters

•  IP Matters Generally:  Discuss with counsel intellectual property matters generally, including desirability/feasibility of prosecuting patents and/or trademarks, securing and protecting IP from founders, employees and others, avoiding IP conflicts with other parties, and desirability of conducing a freedom to operate investigation.
• Trademarks:  Discuss with counsel procedure and expense for securing trademarks in company name or other marks or designs.   If appropriate, work with counsel to complete desired trademark searches and filings.   
• Patents:  Discuss with counsel scope of possible patentable ideas and, if appropriate, work with counsel to coordinate development and prosecution of patent filings.
• Copyrights:  Discuss with counsel need/desire for copyright registrations and appropriate use of applicable copyright notices.
• Domain Names:  Secure domain names and desired alternatives and discuss with counsel issues relating to any conflicts between domain names and TM rights of others.
• Website/Privacy:  Work with counsel to develop and implement appropriate website terms of use and privacy policy and related privacy and registration procedures.  
• Software Development:  As applicable, all third party developers should execute an appropriate assignment of inventions provision with respect to their software development efforts for the startup.
• Indemnification:  Ensure that IP licenses include appropriate indemnification for infringement and related claims.
• Nondisclosure Agreements:  Protect confidential and trade secret information through appropriate use of NDAs.   Work with counsel to prepare form for use by startup.

 Other Matters

•  Insurance:  Consider timing and desirability of obtaining business insurance, including commercial, EPL and D&O coverage.
• Accountants:  Develop relationship with and engage accounts for business.  

Employment Matters – Get It In Writing

Presumably in an effort to save cost and due in part to a “less is more” attitude, founders will from time to time avoid entering into written agreements that they believe are unnecessary to advance the business or protect their interests or the interests of the startup company.   An agreement regarding employment matters often falls into this pile, and  this failure to enter into a simple agreement with co-founders or company employees will from time to time present real problems for a startup company down the road when a dispute arises concerning employment, compensation or rights upon termination.

It is for this reason that I generally recommend that founders get it in writing – enter into written employment arrangements with your co-founders and with future company employees to clarify roles and responsibilities, expectations concerning compensation and benefits, rights (or lack thereof) upon termination, and associated rights and obligations (e.g., stock option grants and non-compete arrangements).   Depending on the specific circumstances, this may also include entering into written employment arrangements with your co-founders upon formation – that’s right, even when there is no money in the bank – addressing, among the other elements in the employment arrangement, the founders’ agreements and expectations regarding accrued salary (or, more likely, the waiver thereof) between formation and initial funding.   For a startup, employment arrangements can be boiled down to a simple offer letter, often no more than 1-2 pages, containing the following essential elements:

Duties.  The offer letter should briefly describe the employee’s position with the startup and his/her duties, the person that the employee will report to (or, if applicable, reference reporting to the Board for certain executives), and should provide necessary flexibility for the company to modify the employee’s duties and responsibilities from time to time.

“At-Will” and Term.  The offer letter should specify that the employment arrangement is “at will”, not for any specified period of time, and subject to termination by either party for any or no reason.   I often see startups get stuck in negotiations among co-founders and startup employees regarding severance upon terminations “without cause” or for “good reason” and I believe startups should avoid severance provisions in offer letters to the greatest extent possible.   Startups just don’t have the funds to deal with severance payments to terminated employees (regardless of why someone is terminated), and in light of the critical role each employee plays a startup needs the flexibility to swap out its people to drive success even if it simply a matter of “fit” and not “cause”.

Compensation/Benefits.  The offer letter should specify the employee’s base salary (or, if an hourly employee, the hourly wage and applicable hourly work schedule), any bonus arrangements (specifying whether bonuses are purely discretionary or, if not, the specific formula, milestones and bonus amounts applicable in each year), and any benefits an employee may be entitled to receive (e.g., health, dental, 401K, vacation, etc.).    If you are entering into an offer letter at formation and prior to a fundraising, your offer letter should specify that the employee/founder is waiving any right to receive compensation until a specific fundraising milestone is met and that the founder’s equity is full compensation for services rendered during such period of time (and the offer letter should also reflect whatever has been agreed upon with respect to accrued salary – i.e., no accrued salary, partial or all, but only once a fundraising happens).   Many if not most benefits will be covered in greater detail in an employee handbook or policy manual and in the specific plan documents for health, dental and 401k benefits, and reference should be made to such manual and plan documents in the offer letter.   Since employee benefits are often changed, the offer letter should state that the company reserves the right to modify benefits (and, if applicable, compensation and bonus arrangements) from time to time as necessary or appropriate.

Equity Grants.    If an employee is to receive a stock option or other equity right, the offer letter should specify the terms of such grant and any qualifications to such grant.    Stock options must be granted by a company’s board of directors or a designated committee, and therefore the offer letter must be carefully worded so that the offer letter does not bind the company before the board or committee takes action.   For example, an offer letter might say “Management of the company will recommend to the Board that Employee be granted an option to purchase 1,000 shares of common stock of the company at the fair market value determined by the Board, but Employee acknowledges that the Board is not required to accept management’s recommendation and that the Board retains the absolute discretion to determine the terms and conditions of Employee’s option grant, if any.”   An alternative (and often preferable) approach is to create an effective consent process with the Board that would allow for approval of option grants in offer letters before the offer letters are sent to provide an actual commitment to an employee on the equity side.

Restrictive Covenant Agreement.    Startups will typically want their employees to be bound by noncompetition, nonsolicitation, confidentiality and assignment of inventions covenants and it is recommended for enforcement purposes to have such agreements executed contemporaneously with and as a condition of employment.   The offer letter should reference (and attach) a restrictive covenant agreement to make clear that it is being executed as a condition of employment.

Right to Work.  The offer letter to contain verification language and, if appropriate, backup documentation supporting employee’s right to work in the United States (whether by citizenship, permanent residency or work visa).

Entire Agreement.   The offer letter should make clear that it reflects the entire agreement between the company and the employee and that there are no other oral or written agreement relating to employee’s employment arrangements with the company.   This provision is important to avoid the possibility that the employee might later claim that in pre-employment discussions management promised employee a certain type of bonus or other consideration that was not reflected in the offer letter.

Intellectual Property 101

 

 

 

Intellectual Property 101

Intellectual property (IP) is often the most valuable asset developed (or being developed) by a startup company.   Generally speaking, IP comprises various forms of intangible property that are subject to ownership and other rights under US laws and the laws of most other countries throughout the world, such as inventions, data or information, brand names and designs, software, video content, music or works of art.   Laws that protect the ownership and use of IP help promote the development, distribution and use of new technologies, valuable copyrightable works, important information and marketable brands, and help establish the framework in which developers and owners of IP may receive a return on the (often significant) investment of time and resources required to develop useful and valuable IP. 

The table below outlines the basic types of IP that are protected under US laws and the legal framework of such protection.   Additional posts in the future will provide additional detail as to each basic type of IP. 

Type of IP	Legal Framework
Patents: An ownership interest (for a limited term) in an invention that is useful, novel, and not obvious.      Most patents are utility patents, which provide protection for patentable machines, goods, processes, compounds and improvements.  Some patents are design patents, which provide protection for patentable designs of commercial goods, such as certain product packaging.   A very limited number of patents are plant patents, which provide protection for certain new varieties of reproduced plants.	The US Patent and Trademark Office (USPTO – www.uspto.gov) reviews and grants (or denies) patents under authority of the federal Patent Act.    A patent gives the right to exclude others from making, using, offering to sell or selling within the US, or importing into the US, the invention covered by the patent.   A utility patent protects the invention for 20 years after the application is filed, and a design patent protects the inventive design for 14 years after the patent is issued.
Copyrights:  An ownership interest in an original work of “authorship” reflecting the exclusive right to reproduce or copy the work, develop derivative works based on the original work of authorship, distribute the work, and perform and display the work publicly.   Works of authorship cover a broad range of catgories, including books, works fo art, music, performances and, importantly, software, web pages and other audiovisual content.	US Copyright Office  regulates copyrights under authority of the federal Copyright Act. Protection arises automatically upon reducing the work to a tangible form, such as a writing, a computer disk, etc.   Copyright Office registration is available but is not required. Exclusive rights extend for 70 years after the author’s death or, for works made for hire, the longer of 120 years from creation or 95 years from publication.
Mask Works:  An ownership interest in a template collections (photographic masks) used to create complex electronic circuits on semiconductor chips, reflecting the exclusive right to copy the work and to import and distribute semiconductor chips based on the work.	US Copyright Office regulates mask works under authority of the federal Semiconductor Protection Act. Copyright Office registration is required. Exclusive rights run for ten years from registration
Trade Secrets: An ownership interest in important technical, business or financial information that the owner maintains as confidential information through reasonable efforts, and from which economic value is derived by virtue of the owner’s exclusive use.	Governed by state law (the Uniform Trade Secrets Act in many states). Rights are secured and maintained by reasonable efforts of the owner to keep information confidential through security and confidentiality agreements.  No registration required. Rights may be retained indefinitely so long as secrecy is maintained.
Trademarks: An owernship interest in names, designs, logos, marks, packages and other devices used to identify goods and services in commerce.	USPTO regulates trademarks nationally under authority of the federal Trademark Act.  Trademarks are also governed by common law and state unfair competitions laws Trademark rights are secured and maintained by commercial use of trademarks within a given field of use.  Right to exclude others from using, in the owner’s field of use, the same or similar mark for the same or similar goods or services in a way that causes consumer confusion. Rights extend indefinitely, until use of mark is abandoned through non-use or failure to comply with statutory and regulatory requirements.

Company Formation – Fiduciary Duties (the Basics)

With deep thanks to Bree Archambault, one of my startup lawyer associates in DBR’s Philadelphia office, for doing the heavy lifting on this post.

As touched on in the earlier post, Company Formation – Separation and Control, directors of a startup are obligated to perform their role as directors in accordance with certain duties to act in the best interests of the startup.   Such duties – “fiduciary duties” being the appropriate legal term – are discussed in greater detail below.   It is important for individuals serving as directors of a startup to understand and abide by such duties, as doing so will benefit, and is in the best interests of, the startup and failing to do so will expose a director who breaches such duties to potential claims and liability.

Duty of Due Care. The duty of care means that directors must act on behalf of the corporation as a reasonably prudent person would under similar circumstances. This comes up in two contexts – active decisions by the board of directors and oversight of the general management of the business. To fulfill the duty of due care, a director must be informed and devote sufficient time and attention to his or her duties as a director. At the most basic level, this includes reviewing relevant materials prior to board meetings; regular attendance at the meetings; and monitoring of management and delegates. Directors should also consider reasonable alternatives to a proposed action and should take the time necessary to make thoughtful and considered decisions with respect to matters presented to the board of directors for approval.     Additional considerations relating to the duty of due care include:

1. Oversight. Within the sphere of due care, the directors also have a duty of oversight regarding the legal and regulatory compliance of the company. This means directors must take affirmative steps to ensure that information and reporting systems exist within the company to provide accurate and sufficient information to management and the board. This is likely easier to accomplish within the smaller startup company, where the founders and initial employees are a close-knit group, who confer with each other for new ideas and perspectives on issues encountered in the company’s growth. In such an environment, the senior management will naturally have the information to relay to directors, without more formalized controls and processes. However, as a company grows larger, with the entrance of angel investors or VCs, it is important to plan for scalable process and controls that allow the board to perform its oversight duties.
2. Use of Experts. The requirement to be adequately informed does not prohibit directors from relying on others for information. Directors acting in good faith may reasonably rely on records, opinions, reports and other forms of information received from a board committee, from the corporation’s officers and employees, or from hired experts within the scope of their professional expertise (legal, accounting, etc.). Delaware (along with most other states) has codified this option. It is important that the board understand the processes and assumptions that underlies the presented information. If a director has reason to doubt the information presented, then he or she should fully vet those concerns. The obligation to dig deeper and acquire more information is proportionate to the importance of the decision at hand.
3. Process. Underlying the duty of due care is an emphasis on process – this originates from the willingness of courts to apply a deferential standard of review to board decisions (see discussion below of the business judgment rule) when the process is documented and the directors took the necessary steps to inform themselves (and met the other fiduciary obligations). Therefore minutes of meetings of the board of directors should memorialize the following good corporate practices: the distribution to directors, in advance of the meeting, of relevant documents and information; the adequate questioning of management, members of committees, and experts whose opinions were provided for consideration; a full and fair discussion of the issue at hand; and the allotment of sufficient time to consider and deliberate the issue, as appropriate.
4. Business Judgment Rule.   Notwithstanding the requirements of the duty of due care, it is important to note that corporate directors are not liable for actions or omissions within the sphere of their business judgment, including imprudence or honest errors of judgment. This is called the business judgment rule. The business judgment rule does not remove the duties of directors to act with due care and with loyalty, but avoids the application of hindsight to business decisions and gives the directors the presumption, under judicial review, that the action or omission was proper. If a decision is challenged, the business judgment rule is applied where the directors acted (1) on an informed basis, (2) in good faith, (3) without a conflict of interest, and (4) in the furtherance of some rational business purpose. The rationale for the business judgment rule is that judges should not second-guess decisions of corporate boards. If the judges ordinarily applied a higher level of scrutiny, it would undermine the entrepreneurial spirit of the marketplace and dampen innovation. Also, judges are not necessarily qualified to act as directors and are not accountable to the shareholders of the corporation (or elected) as the directors are.

Duty of Loyalty. The duty of loyalty requires that directors avoid conflict between their status as director (pursuing the best interest of the corporation) and their personal gain or self-interest.   Directors expose themselves to potential claims and liability if they engage in self-dealing or take advantage of their position on the board to get a plum inside deal with the company (whether an inflated compensation arrangement, preferential terms in a supply or service agreement with the director’s other company, or other favoritism). In the context of startup companies, where founders often serve as both directors and investors or employees, it is especially important to document the decisions and rationale of the board in exercising its duties in situations where there is a conflict of interest. The presence of outside independent directors can help substantiate the fairness and justification of board decisions in these cases.   This is not to say that a company should never engage in inside transactions. The connections and resources provided by the board of directors are often an asset to the startup company. Under the corporate law in Delaware (and most other states), an inside transaction is “cleansed” if the interest of the insider(s) is fully disclosed and the transaction is approved by a majority of the disinterested directors or if it is approved by the shareholders.   However, even after such approval, an inside transaction may be challenged and subjected to a “fairness” review. If the transaction is fair to the corporation, both in price and in dealing, it will be upheld. Fairness may be more difficult to demonstrate without prior approval of disinterested directors. Therefore, if there are not enough disinterested directors to approve a matter (as a consequence of a small startup board or another reason), then the board should take steps to ascertain the transaction is structured as an arms-length deal, at market terms.

Corollary Duties.  As part and parcel to the due care and loyalty duties, directors must act in good faith, maintain confidential information, use candor with other directors, disclose information to shareholders, exhibit independence in fulfilling the role of director, and not take as their own a business opportunity that rightfully belongs to the startup.

Company Formation – Choosing a Company Name

In selecting a name for the startup’s business, founders need to consider a few different legal and business issues:

• “Official” Name of the Startup.    This is the legal name identifying your corporation or LLC with the state in which the startup is formed and in the states in which the startup is qualified to do business.  Startups will need to select a company name that  does not conflict with company names of other businesses organized or qualified to do business in the desired state of formation.    Startups should also consider selecting a company name that does not conflict with company names of other businesses in states in which the startup intends to qualify to do business as a foreign corporation (e.g., a Delaware corporation with headquarters in Princeton, NJ will need to clear the company’s name in Delaware and in NJ).    Most secretaries of state (the applicable government dept in each state in charge of company formation matters) maintain websites with searchable databases of names that are being used or are reserved for future use (you can link to the sites here for: Delaware and NJ).     The founders will need to conduct searches of these databases to confirm that their desired company name is free for use and will not be rejected by the applicable secretary of state upon formation of the startup or filing for entity qualification in another state where the startup will do business.
• Domain Names.   A startup will often desire to obtain domain names consistent with their business names.   Corresponding searches of domain name registries will need to be made to determine if a domain name (and appropriate variations thereof) with the desired business name can be obtained (you can link here to popular domain name registries: go daddy, network solutions and register.com).   Note that this is a separate search from the secretary of state search – an available domain name does not mean that you will necessarily be able to use that name as an official business name, and vice versa.
• Trademarks.  A trademark is a word, phrase, name, symbol or design that distinguishes and identifies a startup’s products, services or business.     There are two preliminary trademark issues to consider when selecting a startup’s name:  (1) does the startup’s proposed name infringe an existing trademark of a similar business, and (2) is the startup’s name protectable as a trademark itself.     Look for a post in the future that dives deeper into trademark law, but for company formation purposes note that it is important to at least do a preliminary search of the US Patent and Trademark Office website – www.uspto.gov- to determine the likelihood of infringement and the ability to protect the startup’s desired name.    Like domain names and official company names, trademarks must be separately searched, cleared and, if desired, registered.    Note:  It is important to note that a startup can brand its business with a trademark and a domain destination that is different from its official business name – a solution that might work when all of the stars do not align.    Back in the dot-com boom time, I was the general counsel of HoopsTV.com – we trademarked the name “HoopsTV,” operated the business from the domain name hoopstv.com, and generally held our business out with that brand – but our actual business name was “The Basketball Network, Inc.”
• A Good Business Name.    I will not even attempt to add to the guidance you can get on this matter from Guy Kawasaki at http://blog.guykawasaki.com/2006/02/the_name_game.html

Employment Matters – Equity Plan Basics

With deep thanks to Ben Lupin, my “go to” associate from DBR’s Philadelphia office for startup equity compensation matters, for putting this post together. 

After forming your entity with the founding group and hiring or engaging additional individuals as employees/directors/consultants, how should an interest in the company be shared with those employees/directors/consultants (for purposes of this post, “key people”) to best align their interests with the founding group and to provide appropriate incentives for work and performance ? 

Goals.  It will likely be desirable for your key people to have a stake in the ownership of the company (or at least for their compensation to be based in part on appreciation in the value of the company’s common stock), and in the startup world sharing stock ownership in one form or another is par for the course.  Stock ownership will help to increase a key person’s identification with the company, to align his or her interests better with that of the founding group, to reward him or her for performance, and to provide him or her with an additional incentive to work hard and produce results.  Offering stock to key people also assists the company in hiring or engaging new key persons, since cash is often very scarce in a startup.  

Types of Awards – The Basics.  There are various types of equity and equity-based awards a company could use to offer its key people an equity interest in the company, or a cash award based on the performance of company stock.

          Stock Option Plans (with two types of options):

            1.  Incentive Stock Options (“ISOs”)

                        a.         The employer grants the employee (non-employee directors and consultants are not eligible for ISOs) an option to buy employer stock.  $100,000 limit on shares subject to ISO which first become exercisable in a year.  Value of shares determined on grant date.

                        b.         Option price may not be less than fair market value (“FMV”) of shares at grant and term must be 10 years or less (110% of FMV and term of 5 years or less if optionee is more than a 10% shareholder).

                        c.         Shares must be held for more than 1 year after exercise and 2 years after grant to receive long term capital gains treatment.

     2.  Nonqualified Stock Options (“NQSOs”)

                        a.         Employer grants the key person an option to buy employer stock.

                        b.         Unlike ISOs, the Internal Revenue Code (the “Code”) does not restrict the term of the option or limit the aggregate value of the option.

                        c.         To meet the requirements of Code section 409A, the exercise price must equal or exceed FMV on the grant date.

          Stock Grant Plans (with two types of stock):

            1.  Restricted Stock.  Employer grants its stock to the key person subject to (i) transfer restrictions; and (ii) a substantial risk of forfeiture which lapses over time (e.g., stock is forfeited in whole or in part if the employee quits or is terminated within 4 years of the grant date).

              2.  Unrestricted Stock.  Employer grants its stock to the key person subject to no transfer restrictions that will lapse.  Typically, subject to permanent transfer restrictions in closely held companies.

          Restricted Stock Unit Plans:  Employer grants units to the key person payable in its stock, but subject to (i) transfer restrictions; and (ii) a substantial risk of forfeiture which lapses over time (e.g., the units are forfeited in whole or in part if the employee quits or is terminated within 4 years of the grant date).

          Stock Appreciation Right (“SAR”): Employer awards the key person the right to receive, without payment, the excess of the employer’s stock’s FMV on the exercise date over its FMV on the grant date; may be paid in stock or cash.  The SAR will be subject to Code section 409A (which requires a fixed exercise date) if it tracks the value of the employer and not the value of the employer’s stock.

Startup Standard.  Most startups rely on a basic stock option plan for granting equity to key persons.    An option plan is fairly familiar to key persons and is relatively easy to administer.  

Documentation.  Documentation for the equity plans above include a governing plan document and forms of individual award agreements to be executed by the company and the key person upon receipt of an equity award.

Eligible Grantees.  Startups need to consider who will be receiving awards: employees, non-employee directors, bona fide consultants, independent contractors, or employees of related entities (if any).  Certain awards are restricted to only certain classes of individuals (e.g., incentive stock options can only be granted to employees). 

Vesting Schedule.  Should the awards be subject to a “vesting” schedule (so that the grantee is entitled to exercise the award or otherwise sell his or her interest in the award) at the date of grant or does the company want to include a schedule so that the awards vest over a set period of time (e.g., 25% a year for 4 years).     Vesting over some period of time or based on achievement of specified performance milestones is common practice and is recommended.   Note that Code Section 83 will likely come into play when issuing awards pursuant to restricted stock and restricted unit grant plans, and an 83(b) election may be appropriate in such circumstances.

Fair Market Value.  An annual appraisal of the company’s value should be done to determine the value of the company (or any material changes to the previous value) for the purpose of issuing awards at FMV.  Whether via an independent entity or done internally by an individual with relevant financial experience, careful consideration should be taken when considering the value of the company and any material changes that would affect that value when determining the fair market value of the shares subject to award. 

Exercise.  The company should consider tax withholding obligations and whether the company desires to use shares to satisfy its tax obligation, as well as when the awards will be exercisable (at termination of employment, death, disability, etc.). 

Approval.  Plans that include equity compensation will likely need to be approved by a company’s shareholders and/or Board of Directors.  It is often advisable to build-in as many types of awards into a plan, even if the company does not anticipate granting certain types of awards, in order to avoid having to go back to the company’s shareholders for approval of a new type of award at a later date.  The shareholder approval should also include the total number of shares that will be available under the plan. 

Accounting and Tax Treatment.  Both of these factors should be considered before a plan is adopted.  The company should consult legal counsel or an accountant to discuss the applicable rules and the advantages and disadvantages that may accompany the various awards.

409A issues.  In general, Code section 409A provides that deferred compensation cannot be paid except upon the occurrence of one of six specific events: (1) fixed date(s), (2) separation from service, (3) death, (4) disability, (5) change of control, or (6) hardship.  Certain equity-based awards are considered deferred compensation under section 409A, including stock options, stock appreciation rights and phantom stock awards.  However, if certain conditions are met (e.g., the exercise price is equal or greater than the underlying stock’s fair market value on the date of grant), such awards will be excepted from Code section 409A.     Significant penalties attach to awards granted in violation of 409A.   As a result, it is important to follow the guidance provided by the startup’s attorney in granting and administering the awards under a company’s plan to avoid 409A penalties.

Company Formation – Separation and Control

When forming a startup, founders need to understand and appropriately address two important and related governing issues for the startup entity: separation and control. 

Separation.

By “separation”, I mean that the founders need to understand that the startup is a separate and distinct legal entity and needs to be controlled, governed and operated as such.    Even solely among a group of founders (before investors and employee-owners), any one founder cannot act as if the startup is “my company” to do with as that founder pleases and without consideration for the rights of the other founders or the best interests of the startup.     After investors and employee-owners join the startup, the need for founders to separate their personal interests and objectives from that of the startup becomes even more important due to the different and sometimes conflicting  interests and legal and contractual rights associated with different groups of stockholders.   Failure by a founder to appropriately separate the founder’s interests and objectives from the startup’s interests and objectives, even when the founder “controls” the startup, can result in complicated problems and potential legal liability.   

Such conflicting actions can take many forms:  the founder who regularly uses company funds for personal purposes, such as to pay for meals with no business purpose or to acquire assets (laptops, iPhones, etc.) that are used more for personal purposes than for business purposes; the founder who engages in insider transactions with the startup without seeking approval from the independent directors or stockholders, whether such insider transactions are with other companies in which the founder has an interest or with other persons with whom the founder has a close relationship; the founder who sets compensation for himself on a materially higher scale than others without a real business justification; the founder who tries to sell the startup early and make a quick buck when the other investors and employee owners are engaged in building the business for the long haul; etc.     It is not only bad business for a founder to take such actions, taking such actions in the founder’s interests and not in the startup’s interests can also open a founder up to litigation and potential legal liability.  Basic guidelines:  understand that the startup is a separate and distinct legal entity and must be governed and operated as such, and understand  that, as a founder, you will need to be acting in the best interests of the startup when you are acting in your capacity as an officer and director of the startup; you will need to be sensitive to how conflicts are dealt with, including obtaining approvals from non-interested directors/stockholders when appropriate; and you will need to carefully “wear two hats” – one being looking out for your own personal interests as a founder, stockholder and employee and the other being looking out for the best interests of the startup (often with a need to lean in favor of the startup’s best interests).  

So, hopefully with a slightly better understanding of why founders need to separate their personal interests and objectives from how they control and operate a startup, let’s consider how a startup is actually controlled and governed.

Control.

Control of a startup – which for purposes of this post we will assume is a corporation or an LLC organized, as is often the case, with a corporate-type governance structure – is divided among the startup’s owners, the startup’s board of directors, and the startup’s officers.   

The board of directors is the body with the centralized authority over the business and affairs of the startup.   All corporate powers and decisions are ultimately exercised under the authority and supervision of the board of directors.   The board of directors has the power to appoint and remove officers of the startup and delegate day-to-day management responsibilities to the startup’s officers,  and typically will do so, but ultimately such officers are acting under, and subject to, the authority and oversight of the board.    Directors are obligated to act in the best interests of the startup and its stockholders, and are bound by certain fiduciary duties to act with due care when making decisions on behalf of the startup and to be loyal to the startup (more on this in a later post).   Generally, the board of directors will approve material corporate actions and actions outside the ordinary course, such as officer and key employee apppointments, venture financings, material commercial agreements, bank financings, sale of the startup, etc., and unless otherwise specified in the startup’s charter or bylaws a board approves such actions by a majority vote at a meeting or by unanimous written consent.  When forming a startup, the founders need to determine who will be on the board of directors and, therefore, who will ultimately exert primary control over the startup.   It does not necessarily follow that all founders should be on the board of directors, nor should the board be limited to just one or more founders – independent directors can often bring valuable experience, insight, independent judgement and contacts to a startup’s board of directors.    Note that an important consideration is to structure the board to avoid the possibility of a deadlock in decision-making that might hamstring the startup (e.g., a two person board made up of two founders may not be ideal – adding an independent third director might be considered in this scenario for additional insight and guidance and to break potential deadlocks).    Other important considerations at the startup stage is to keep the size of the board small enough (probably no need for more than 3 directors before a startup takes on investors), and the relationships, personalities and skillsets of the directors cohesive and complementary enough, so that the board is informed, engaged and communcating well among themselves and with management, and can act quickly and effectively when the board needs to consider matters and act.

A board’s centralized authority over a startup is checked to some degree by the authority of the stockholders of the startup.   The stockholders have the authority to appoint and remove directors, and the stockholders have the right to vote on extraordinary corporate actions (e.g., venture financings, sale of business, amendments to charter, etc.).    However, the stockholders, as stockholders, have little voice in the day to day business of the startup.  In the context of a startup, the stockholders are typically the small group of founders (who are also, in part, the officers and directors of the startup), and often they will enter into a voting agreement to appoint one or more founders to the board of directors.   As a result, there is not much of a check on the board of directors by the stockholders for an early stage startup.   This check will become more meaningful when the startup brings on investors, who will have differing interests, will desire to have the right to appoint one or more board members, and will likely negotiate for a laundry-list of specific stockholder approval rights to be voted on by the investor group.     At this stage, the check on the power of the board of directors becomes meaningful, and a certain amount of control over the startup will shift away from the exclusive power of the board of directors to one of shared control between the board of directors and the stockholders.

Officers of the startup control the startup’s day to day activities, but as indicated above such control is always subject to the authority and supervision of the board of directors.    Due to the oversight and supervision of the board, and due to the board’s ability to remove officers, officers do not really control the startup, but they certainly control an extraordinary number of day-to-day activities and decisions that can make or break the startup.     As a result, competent, experienced and trustworthy officers are key to forming and running a successful startup.

Employment Matters – Making a Clean Break (Leaving Your Employer)

A few important rules of the road when considering quitting your job to form a startup:

Review Employment-Related Agreements/Policies:  Employees often execute a variety of agreements with an employing company at the beginning of, and during, an employment relationship.     Employees may also explicitly or implicitly agree to be bound by employment policies/handbooks of an employing company.  And there are also common law obligations, particularly with regard to confidentiality, that the law imposes on everyone, regardless of whether they have an agreement with their employer or not.   These agreements, policies and laws often contain a variety of restrictions on the employee’s activities both during the employment relationship and after termination, and such restrictions may impact (sometimes, significantly) an employee’s ability to form a startup shortly after quitting a job.  As a result, any existing agreements and applicable policies need to be collected and reviewed carefully, and in many cases advice of counsel should be obtained, to evaluate the applicable restrictions and determine the risks and potential limitations of forming and operating a startup that may be covered by one or more provisions of any such agreements. 

Such restrictions often include:

•             Noncompete:   Employees are often bound by noncompetition covenants whereby an employee agrees during the period of employment and for a period thereafter (often at least one year) not to engage in any activity that competes with the employing company or a particular business unit of the employing company. 
•            Confidentiality:  Employees are often bound by confidentiality covenants whereby an employee agrees that, at all times during employment and in the future, he or she will not disclose or use any confidential information of the employing company for any purpose other than for the employing company’s business.  State common law also protects against a former employee using the confidential information of his or her former employer.
•            Nonsolicitation:  Employees are often bound by nonsolicitation covenants whereby an employee agrees during the period of employment and for a period thereafter (often one to two years) not to solicit or hire any other employees of the employing company, and not to solicit or engage for any purpose any of the employing company’s customers or vendors.
•             Assignment of Inventions:      Employees are often bound by assignment of inventions covenants whereby an employee agrees during the period of employment that any invention, idea, technology, etc. related to the employing company’s business and developed by an employee during the period of employment (whether in the office or at home) is owned by the employing company.
•             No Moonlighting:  Employees are often bound by “no-moonlighting” covenants whereby an employee agrees during the period of employment not to engage in any other business activities, including any activities after normal work hours.

The application of such restrictions may significantly restrict the formation and operation of a startup and/or its ownership of important intellectual property, and litigation over the application of such restrictions can be very expensive and distracting to a new startup and its founding group.  It is therefore critical to evaluate such restrictions carefully, abide by such restrictions while still employed (including, importantly, not developing any intellectual property intended for the startup to avoid an ownership claim by the employing company), determine (with the advice of counsel) the best timing for exiting an employment relationship and the best strategy for avoiding litigation over potentially applicable restrictions, and implement necessary changes to the startup’s development, business and operational strategy to avoid (or at least limit) potential conflicts arising from such restrictions.   

Do Not Take or Use Trade Secrets of Former Employer:  A “trade secret” is valuable information that the employing company (i) keeps strictly confidential, such that it is not generally known or available to competitors or others in the applicable industry, and (ii) receives a competitive advantage from its use and secrecy.   Customer lists, processes, techniques, technologies, formulas, devices can all be trade secrets.   Even without a confidentiality agreement, unauthorized use or disclosure of trade secrets of an employing company is in most cases prohibited during the employment period and thereafter.   So a prospective founder of a startup should not make plans to use, disclose or rely upon trade secrets of the employing company in connection with launching and operating the startup.

Planning Is Acceptable; Actions Often Are Not:  While still employed, an employee needs to limit what actions are undertaken in developing a new startup enterprise, particularly when such startup will be competitive with the employing company.   A general rule to follow (subject to any applicable contractual restrictions):  making plans to develop such a startup is permissible (e.g., market research; business planning; general discussions with potential founders; etc.); taking actions to develop such a startup (particularly one that will compete with your current employer) is often not permissible (e.g., forming the company; developing or marketing the product; launching the website; etc.).  Key employees and employees with special skills critical to the employing company will be subject to higher standards when evaluating what actions may or may not be taken (such employees have an implied duty of loyalty to their employer), and such employees should avoid taking any actions that may be detrimental to the employing company prior to terminating their employment relationship.

Do Not Plan On Company Time/Equipment:  Separate any startup planning activities from the employing company’s workday, employees and equipment.  An employee should avoid engaging in planning activities during the workday, when such employee should be working exclusively for the employing company.   An employee should avoid using any of the employing company’s equipment (including the employing company’s computers) for planning activities.  And an employee should avoid soliciting co-workers while still employed, even if such employee is not bound by a nonsolicitation restriction.

 Be Prepared to Promptly Return Company Property:  Laptops, mobile phones, company records, customer lists, confidential information, and any other property or materials of the employing company are exactly that, property and materials of the employing company.  An employee seeking to make a clean break and form a startup should not complicate matters by attempting to keep, or delaying the return of, company property.  Such actions will only serve to agitate and raise questions at the employing company, which may result in a greater likelihood of litigation over such matters or over potentially applicable restrictive covenants. 

Review Equity/Bonus Incentives:   An employee should evaluate what rights might be extinguished at or shortly after termination of employment.  For example, stock options often expire 90 days after termination and then they are lost forever.  An employee should consider what incentives he/she may be giving up depending upon the date of termination and how best to secure such incentive arrangements by delaying termination (for example, in the case of a year-end bonus) or by taking actions to appropriately secure applicable rights (for example, by timely exercising stock options).

Try To Leave on Good Terms:   Not necessarily the easiest thing to do, particularly if the startup is going to be competitive, but try you must.   An employing company is much more likely to bring claims against the startup if the employment relationship ended on bad terms or if the former employee was deceptive when asked why he/she was leaving and what he/she planned on doing.     

Company Formation – Choosing the Right Entity

As part of forming a startup business, the founders will need to select a form of business entity to launch the enterprise and to create the formal structures that separate the startup business from the founders as individual owners and operators of that business.   Among the possible entity choices are corporations (including “C” and “S” corporations), limited liability companies, partnerships and sole proprietorships (although a sole proprietorship is not really an entity separate from the owner), all of which vary to a significant degree in terms of taxation, liability protection for owners, ownership structures, governance, capital raising, employee equity incentives and documentation.   It is easy for founders to get lost in attempting to balance the positive and negative attributes of each possible choice in light of the founders’ specific circumstances, but based on a fair degree of experience I believe the choice can be greatly simplified: a Delaware “C” corporation is the startup entity of choice for businesses that (1) are being formed without significant capital contributions by the founders, (2) anticipate raising multiple rounds of venture financing, (3) intend to provide equity incentives to employees, and (4) do not intend to distribute current earnings to owners on a regular basis, but instead anticipate reinvesting earnings back into the business.   This general rule captures the intent of many, if not most, technology and similar startups, with the result being that most startups should (and will) be formed as “C” corporations (and, most often, in Delaware).

Why a Delaware C Corporation

A corporation is a separate legal entity organized under the laws of a specific state.   It is owned by one or more shareholders, who elect a board of directors to oversee the important activities of, and make the important decisions for, the corporation.  The board of directors appoint officers, who are responsible for managing the day-to-day business of the corporation.  The shareholders, in their capacity as shareholders, are not actively engaged in managing the corporation, and benefit from the corporate structure by not being held personally liable for the debts and liabilities of the business. 

This basic business structure works well for startups, and it is the business structure that entrepreneurs and investors have become most comfortable with.  Most public companies are C corporations, as C corporations may have an unlimited number of shareholders and shares in a C corporation are freely tradableoutside of contractual restrictions agreed to by the shareholders and compliance with applicable securities laws.  Venture investors have a preference for investing in C corporations because a C corporation can be structured with multiple classes of stock, allowing for the creation of preferred stock with enhanced rights, preferences, and protections as compared to common stock and because venture funds prefer not to invest in entities with flow-through tax treatment, such as LLCs, partnerships and S corporations, as such investments create potential tax issues for certain types of limited partners who commonly invest in venture funds.    C corporations have the ability to offer incentive stock options to employees (an equity incentive arrangement that employees and entrepreneurs are very familiar and comfortable with), allowing employees to participate in the rewards of the business in a manner that defers tax on the equity compensation until the employee sells the common stock underlying the option.  C corporations have the ability to offer certain fringe benefits to employees, with the cost of such benefits being tax-free to the employee and tax-deductible to the corporation. C corporation organizational and investment documentation have become highly standardized due to the preference for such entities by entrepreneurs and venture investors, with the result being that significant cost and timing efficiencies have been created by using a C corporation as a startup, venture backed entity. And the C corporation structure is familiar and predictable to founders and investors alike, due to well-defined state statutes and a long history of applicable caselaw (and among all of the states, Delaware stands out as having the most well-developed and transaction-friendly corporation laws, the most clearly articulated caselaw, and the most experienced judges, such that Delaware has become the preferred home for forming a corporation).

C corporations are, of course, not perfect (what is?).   C corporations are separate taxable entities, and under federal income tax law a C corporation will be taxed at rates ranging from 15% to 35% on its net income (gross income less allowable deductions).   If a C corporation makes a distribution or pays a dividend to its shareholders, the shareholders will be taxed on such dividends or distributions resulting in a double layer of tax (one tax on net income received by the corporation, another tax on the dividends and distributions received by the shareholders).   While double-taxation is not really desirable under any circumstances, the impact of this tax structure to a startup is limited because a  startup typically does not plan on making distributions of net income to owners on a regular basis (most often net income is reinvested to build and enhance the value of the business).    C corporations also must comply with a range of corporate formalities in order to preserve the limited liability status of the corporation’s shareholders, such formalities to include keeping books, records and funds for the corporation separate from the personal books, records and funds of the shareholders; holding regular board and shareholder meetings and obtaining and recording a significant number of legally required board and shareholder consents and actions; sufficiently capitalizing the corporation; maintaining an arms’ length relationship between the corporation and its principal shareholders and obtaining disinterested board or shareholder approval of any related party transactions between a corporation and its principal shareholders; and conducting business under the name of, and through, the corporation and not directly on behalf of any shareholder.   While foregoing corporate formalities may seem somewhat rigid, the organizational discipline and good recordkeeping practices established by following such corporate formalities outweigh, in my opinion, the limited difficulties caused thereby.

Taking into account and balancing all of the foregoing (and other) considerations, the result is more often than not to form a startup entity with the key intended attributes as outlined in the first paragraph above as a Delaware C corporation.   That being said, there are certainly situations where founders and investors alike would benefit in the short or long term from forming and operating an alternative startup entity, typically an S corporation or a limited liability company.   This may occur when one or more of the key attributes of a startup identified above differs in a particular situation (i.e., the startup (1) will be formed with significant capital contributions by the founders, (2) does not anticipate raising multiple rounds of venture financing (and anticipates capital to come mainly from investors that are not venture funds), (3) does not intend to provide equity incentives to employees (or is willing to address the additional complexity of providing equity incentives to employees outside of a C corporation structure), and (4) intendsto distribute current earnings to owners on a regular basis.  Such a decision will require a more complex analysis and discussion with attorneys and tax advisors, and to avoid creating confusion with too much detail I have chosen not to dive deeply into this analysis.    I leave you with the general rule on choosing a startup entity provided in the first paragraph above (together with the specific situations mentioned in this paragraph) when you may want to consider an S corporation or LLC alternative), and the guidance to consult with your attorneys and tax advisors when forming your startup entity to make sure that the founding team is appropriately balancing all considerations.     For a bit of context on the S corporation and LLC alternatives, some general points are set forth below.

When to Consider an S Corporation Election at Formation

An “S” corporation is similar in terms of legal structure, liability protection, corporate documentation and the need to follow corporate formalities as a C corporation, with some very critical differences.   An S corporation is not allowed to have more than 100 shareholders, and all of an S corporation’s shareholders must be individuals (only U.S. citizens or resident aliens) or certain types of tax exempt organizations, trusts or estates (as a result, a venture fund cannot invest in an S corporation).   An S corporation may only have one class of stock (as a result, an S corporation cannot issue preferred stock to angel and institutional venture investors).  An S corporation is not treated as a separate taxpayer – profits and losses of the business are allocated to the shareholders based on share ownership and the shareholders (and not the corporation) pay the tax on profits, or receive the tax-deductible benefits of the losses (to the extent of a shareholder’s tax basis in the corporation), of the business (so no double taxation for an S corporation).   S corporation status is obtained by filing a Form 2553 with the IRS, together with a written consent of shareholders, on or before the 15th day of the third month of the taxable year for which S corporation status is to be effective.  And S corporation status can easily be revoked by making certain additional filings with the IRS (with the advantage – as between an S corporation and a limited liability company - being that the S corporation’s organizational and other documentation will not need to be redone to convert to a C corporation).

S corporations are most often used for small or closely-held businesses that distribute the business earnings to their shareholders on a regular basis and desire to avoid two layers of tax, but in certain cases when all of the shareholders also work for the business and receive business earnings by way of salary and bonuses the advantages of an S corporation may be limited.    With respect to a startupcompany that will be generating losses and not earnings prior to a venture funding (and, most likely, for some time thereafter), there may in certain circumstances be advantages to electing S corporation status upon formation (with the expectation to revoke such status prior to a venture funding).   If the founders or the startup’sinitial individual investors (which may also be the founders) are contributing seed capital to the corporation (remember, for common stock only) and such persons can take advantage on their individual tax returns of the startup’s business losses, an S corporation election during the period between formation and initial venture funding may be advantageous.  Note, however, that an investment by the founders or individual seed investors in common stock of the corporation will set a higher price for the common stock than if such investment was made in preferred stock, with the result being that the startup will be granting options to key employees at potentially higher exercise prices (most likely not a desirable outcome).  

 When to Consider Forming a Limited Liability Company

A limited liability company is a business entity that combines a C corporation’s liability protection for its owners with an S corporation’s flow through tax treatment, and does so in a manner that provides much greater economic, tax, ownership and operational flexibility when compared to corporations.  An LLC does not have any of the ownership restrictions of an S corporation.  An LLC has greater flexibility in allocating profits and losses to the owners (called “members“) of the LLC as compared to an S corporation.  An LLCcan be organized with the same corporate formalities as are required of corporations or can be structured to provide much greater flexibility in terms of governance and operating provisions.  And an LLC can be converted to a C corporation on a tax-free basis to the members at any time.  

So, as with the S corporation, there are certain circumstances when a limited liability company structure may be an appropriate business structure for a startup, particularly when the members can take advantage of the tax losses in the business, it is anticipated that outside funding will either not be needed or will come from individual investors in a limited number of rounds as compared to venture funds or other institutional investors, and/or when it is anticipated that business earnings, once generated, will be distributed to the members on a regular basis.    There are increased compliance costs in operating an LLC due to complicated partnership accounting rules and, although an LLC can be converted into a C corporation at any time, such a conversion is complex and can be expensive, so the factors above (as well as other factors to consider in forming an LLC) must be considered carefully with the startup’s attorneys and tax advisors to determine if an LLC structure is best. 

 

 

 

Founders’ Stock – Overview

Below is a simple overview of the basic elements to consider in connection with issuing equity to a group of founders upon formation of a startup.   NOTE:  Throughout this post, and in the related posts on Founders’ Stock, I refer to “stock” (equity in a corporation) and not “units” or “membership interests” (equity in a limited liability company) since most startups that will seek venture backing are formed as Delaware C corporations and not as limited liability companies (for my thoughts on this issue, see my related post on choice of entity).   That being said, many of the basic points outlined below remain applicable to a startup that is a limited liability company, but additional tax, accounting and related matters will need to be considered in granting founders equity in a limited liability company.

• Identify the Founders.    Determine who is on the team.  This is not an all-inclusive list of everyone that might advise the business from time to time, write a piece of code, design a logo, etc.  This is the list of key players who commit to the success of the business, provide valuable skills and intellectual capital to the business, and are prepared to devote a significant portion (or, better yet, all) of their professional energies towards making the business a reality.
• Confirm No “Lost Founders”.  Consider whether there are any individuals who may have contributed in some meaningful, even if limited, way to the business and who may, even if unlikely, have some claim to the business idea or the initial intellectual property developed.   A partner in the startup’s initial school business plan competition?  An individual who wrote some code for the beta version of the startup’s website?   A fellow student (finance major, perhaps?) who assisted in developing the startup’s business model?   Even if these individuals are not going to be part of the founding team because they are not committed and/or key to the future of the business, they may need to be dealt with (whether by obtaining a waiver or an assignment of intellectual property, or granting them a small piece of equity) in order to avoid the possibility that they bring an ownership claim against the company/founders at some point in the future.
• Evaluate Founder Restrictions.   Determine whether any founder is subject to restrictions that need to be addressed, such as a founder being subject to an applicable noncompete, nonsolicit or confidentiality agreement, a founder being subject to policies (such as university IP policies) that may complicate ownership of intellectual property developed by such founder, a founder needing to make a clean break from his/her current employer, or a founder not able to devote the same degree of effort as the other founders due to other professional or personal obligations.    For some guidance on these matters, see my related post.
• Discuss Employment/Noncompete Matters:   It is fairly customary for the founders, as well as all other key employees, to execute restrictive covenant agreements for the benefit of the startup, such covenants to include a confidentiality agreement (the founder will hold all information of the startup confidential and not use it for any purpose other than for the startup’s business), a non-solicitation agreement (the founder will not solicit employees or customers of the startup for a period of time after leaving the startup), an assignment of inventions agreement (all intellectual property developed by the founder relating to the startup’s business will be owned by the startup) and a noncompete agreement (the founder will not directly or indirectly compete with the startup while actively engaged and for a period (typically one year) after ceasing to be actively engaged with the startup.    It is also important for the founders to discuss and reach some consensus on roles and responsibilities, as well as compensation arrangements, for the period between formation and initial funding (foregoing compensation or deferring compensation until a funding round – note, however, that investors may resist attempts by founders to take a portion of investment proceeds as deferred compensation) and for the period commencing on the initial funding.   While these matters do not relate directly to the issuance of founders stock, they are important pieces of the founders’ arrangements and must be discussed and considered in connection with determining how best to allocate equity among the founding group.
• Divide the Equity Among the Founders:  The founding group will need to reach a consensus on how to “fairly” split up the founders’ stock in the startup.  For some guidance on this subject, see my related post.
• Consider Control Issues:  Connected to the division of equity among the founders is the important concept of control.   Is there a single founder that gets to make all of the final decisions?  Is some type of consensus needed?  What happens if there is no consensus or if there is a deadlock?  Founders are often working well together at formation, and often they have close personal relationships, such that they believe that conflicts will not arise.   Better to plan for the inevitable conflicts by thinking through key control decisions (hiring new key employees; closing a capital raising transaction; entering into an important licensing or partnership agreement; etc) and how the founders will resolve such decisions if there is a disagreement.
• Consider Future Dilution:  Dilution happens; it is not something to fear.   Key consideration is for the founders to recognize that they need to be focused primarily on building the biggest business possible – a small piece of a very big pie is most likely better than half of a very small one.   That being said, the founders need to know how dilution works so they are level set in terms of expectations.   Here is a simple example:

Assume three founders with allocated founders stock as follows:

Stockholder	Shares	Ownership %
Founder A	600,000	60%
Founder B	200,000	20%
Founder C	200,000	20%
Total:	1,000,000	100%

Now assume that our founders understand the need to bring on additional key players and provide them with equity incentive packages.   At formation, our founders establish a stock option plan for 20% of the total equity, so that as options are granted out of such plan our founders are diluted in terms of their ownership interest in the startup. Result:

Stockholder	Shares	Ownership %
Founder A	600,000	48%
Founder B	200,000	16%
Founder C	200,000	16%
Stock Option Plan	250,000	20%
Total:	1,250,000	100%

Now assume a Series A financing with a single venture capital firm, at which time the venture capital firm invests $1,000,000 in the startup at a $3,000,000 pre-money valuation, resulting in the venture firm owning 25% of the startup on a fully-diluted basis.  Result:

Stockholder	Shares	Ownership %
Founder A	600,000	36%
Founder B	200,000	12%
Founder C	200,000	12%
Venture Fund	416,667	25%
Stock Option Plan	250,000	15%
Total:	1,666,667	100%

And the story continues from there with additional dilution resulting from additional capital raises, increases in the size of the option plan as needed to hire more key employees, issuances of warrants to consultants, vendors or lenders in connection with important commercial arrangements, etc.  The founders do their best to limit their dilution by, hopefully, raising capital at an attractive pre-money valuation and by being conservative in issuing equity incentives to employees and others, but ultimately dilution is inevitable - it is only a question of how much dilution.  But, let’s remember the important lesson:  while it is certainly valuable for the founders to work towards retaining as large of an ownership interest in the startup as possible, the reality is they need a lot of help from a lot of people  to build a really big business – help from additional key employees, help from capital sources, help from lenders, vendors and strategic partners – and the founders will need to share in the rewards of building that really big business with the individuals and entities that help them along the way.    If they are truly successful, the startup will turn into that really big business and the founders ownership interest will not be the primary determinative factor in how much reward the founder takes home, it will be the size of the business created.

• Vest Founders’ Stock:  In most cases, vesting of founders stock is appropriate.   The founders group will need to determine in what manner each founder’s stock should vest.   For some guidance on this subject, see my related post. 
• File 83(b) Election:  If the founders’ stock will vest, the founders will need to file an 83(b) election with the IRS within 30 days of the purchase of the founders’ stock.   For some guidance on this subject, see my related post.
• Discuss Transfer Restrictions.   It is customary and appropriate for there to be significant restrictions on transferability of founders stock – often resulting in no transfer rights for stock that has not vested, very limited transfer rights on stock that has vested (for example, only permitting transfers of stock for estate planning purposes), and rights of first refusal on any permitted transfers outside of the estate planning context.   Transfer restrictions serve the primary purposes of keeping the founders appropriately incentivized by not permitting them to cash out early and maintaining the stock (and, as a result, control of the startup) within the hands of those founders, managers and investors who are closely tied to the business and are best able to make decisions on behalf of the startup.    The founding group should reach a consensus on the scope of transfer restrictions to apply to their founders stock, and on any exceptions that may apply.
• Document The Arrangements.   In addition to the basic company formation documents, the foregoing matters – once determined – need to be documented among the founders and between each founder and the startup.   Such documents will typically include a restricted stock purchase agreement  between each founder and the startup (addressing the acquision of founders stock, vesting provisions, and transfer rights and restrictions relating to the founders stock), a stockholders agreement among the founders and the startup (addressing the structure of the startup’s Board of Directors to address control issues and, in some cases, transfer rights and restrictions and buy/sell provisions), a restrictive covenant agreement between each founder and the startup (addressing confidentiality, inventions assignment and noncompete restrictions) and an employment letter (memorializing the role, responsibility and future compensation arrangements of the founder).
• Do It Early:  There are a number of reasons to form the startup and allocate the founders stock early in the process, including confirming as soon as possible that there is a clear alignment of interests among the founders; purchasing founders stock at a nominal price with limited tax risks (issuing nominally priced stock to founders too close in time to an investment round creates tax risks for founders - the IRS may challenge the nominal price as being too low and tax the founders based on the difference in value between the nominal price and the actual FMV of the founders stock as determined by the IRS which may be closer in price to the price paid in the investment round); avoiding the “lost founder” problem; establishing the entity to own the business idea and the developing intellectual property, etc.   This is not a call to rush to form some entity, any entity, just to check the box – I have seen that happen and have had to unwind such entities and reform the startup because a group of founders just went ahead and formed an entity and assumed that was the end of the story.  Not a good idea.  The lesson is to realize that organizing the entity and issuing the founders stock properly, with guidance from your lawyer, is not a can to be kicked down the road.  When it looks like the founding group is committed and ready to take the business idea seriously and/or when important intellectual property is being developed, it is time to begin thinking through the matters above and other entity formation issues and get the startup formed.