NYTECH Presents "Legal Essentials for Startups: Part 1 of 3 - Organizing the Entity"


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Hosted by the New York Technology Council (www.nytech.org) on October 25 at Anchin.

Presented by:
-Paul Ellis, Paul Ellis Law Group
-Frode Jensen, Holland & Knight
-Glen Westerback, Frankfurt Kurnit Klein & Selz

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NYTECH Presents "Legal Essentials for Startups: Part 1 of 3 - Organizing the Entity"

  1. 1. Legal Essentials for Startups:Part 1 of 3 – Organizing the Entity Frode Jensen October 25, 2012 1375 Broadway, New York, NY
  2. 2. DisclaimerThe materials and information contained in this presentation are presented for informationalpurposes only and do not constitute advertising, solicitation or legal advice. Although carehas been taken to ensure that the materials are correct, complete and up-to-date, thepresenters and their firms assume no responsibility therefor. Accordingly, you should notact or rely on any information in this program without seeking the advice of an attorneylicensed to practice law in your jurisdiction.The materials contained in this presentation do not create and are not intended to create anattorney-client relationship between you and any of the presenters, Holland & Knight LLP,Paul Ellis Law Group LLC or Frankfurt Kurnit Klein & Selz. 2
  3. 3. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 3
  4. 4. Holland & Knight: Who We Are• Our profile – Holland & Knight is a global law firm with approximately 1,000 lawyers in 21 offices in the U.S. and abroad – We have been named by BTI as one of the top 10 firms in the U.S. for client service, reputation and innovation (June 2012)• We are value and service-oriented – We work as a team using a “one firm” structure for matters ranging from simple to complex – We draw upon our broad legal experience and industry knowledge to provide efficient, high value service• We are innovative – We offer a broad range of perspectives that a diverse team brings, thus encouraging innovative thinking and unique solutions• We are diverse – Our lawyers reflect the national and international marketplace as well as communities in which we practice 4
  5. 5. Holland & Knight Offices Portland Boston Chicago New YorkSan Francisco Washington, D.C. Northern Virginia Los Angeles Atlanta Tallahassee Jacksonville Orlando West Palm Beach Tampa Fort LauderdaleInternational Offices Lakeland MiamiAbu Dhabi, United Arab EmiratesBeijing, ChinaBogotá, ColombiaMexico City, Mexico 5
  6. 6. Today’s Panel 6
  7. 7. Frode Jensen Frode has represented numerous entrepreneurs, managers and institutional and individual investors in startups, early stage companies and growth companies in a wide range of industries, including biotechnology, pharmaceuticals, communications, data collection, retailing and distribution, as well as numerous "old economy" industries.Frode Jensen Practice Education Bar AdmissionPartner • Venture Capital & • Williams College, B.A. • New YorkHolland & Knight, LLP Private Equity • Columbia University • Connecticut212.513.3462 • Corporate Law School, J.D. Governancefrode.jensen@hklaw.com • Mergers & Acquisitionwww.hklaw.com • Financial Services 7
  8. 8. Glen K. Westerback Glen counsels clients on software, e-commerce and Internet issues, including matters related to classic Web-enabled commerce, privacy and data security, blogging and social networking, cloud computing, online advertising, and the development and licensing of websites, mobile apps, and other software and leading edge innovations. Glen also helps media, technology and other innovative companies organize and reorganize, structure entrepreneurial ventures, and access financing. He has advised clients on mergers and acquisitions, marketing and distribution agreements, licensing of intellectual property, and services agreements, employment, and other corporate arrangements.Glen K. Westerback Practice Education Bar AdmissionAssociate • Corporate and • The College of William • New YorkFrankfurt Kurnit Klein & Selz Finance & Mary, B.A.212.826.5563 • Technology, • Cornell Law School, eCommerce and J.D.gwesterback@fkks.com Privacywww.fkks.com 8
  9. 9. Paul Ellis Paul is a founding board member of the New York Technology Council (NYTECH) and leads NYTECH’s bi-monthly series of legal events. He has represented companies ranging from startups to multinationals, as well as funds and individual and institutional investors. Paul counsels on issues including formation, early-stage financing, joint venture and strategic partnering relationships, employment, equity plans, mergers and acquisitions, and, together with his colleagues, protection and licensing of intellectual property. Beyond the software/internet/IT industries, he has practiced in industries including telecommunications, healthcare, manufacturing, banking, real estate, consumer products and entertainment.Paul Ellis Practice Education Bar AdmissionManaging Member • General Corporate/ • Harvard University, • New YorkPaul Ellis Law Group LLC Contracts B.A.212.949.5900 • Financing/Venture • Georgetown University Capital Law Center, J.D.pellis@pelglaw.com • Intellectual Propertywww.pelglaw.com 9
  10. 10. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 10
  11. 11. Preliminary considerations: Show stoppers• If an idea seems to have a commercial application – if it entails a product or service which could be traded for money – the possessor of the idea should consider: – Does the idea belong to someone else? • Am I subject to an employment agreement which gives rights in the idea to my employer? • Is the idea clearly subject to someone else’s copyright, trademark or patent? – Am I restricted from competing? • Am I subject to a restrictive employment agreement or a non-competition agreement? – Am I restricted from asking colleagues from a prior employer to partner up with me? • Am I subject to a non-solicitation agreement?• If the answers are no, let’s go! 11
  12. 12. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 12
  13. 13. South Park Plan: How Not to Start a Company 13
  14. 14. Lifespan of a business “Idea” Organization Exit of startup company Lifespan of a business Optimize potential Execution of idea/ and operate build prototype Implementation of strategy/revenue stage 14
  15. 15. Starting up 15
  16. 16. Trigger event for organizing an entity• It is often difficult to define a rule of thumb for the triggering event that should lead an entrepreneur to move from “brainstorming” to deciding to organize a business as a more formal entity• The following circumstances can act as a trigger: – The founder begins to spend more than just a trivial amount of money on the startup – The possibility of commercialization of the “idea” becomes reasonable – There are co-founders or the founder is contemplating taking on partners or asking for other people’s money – The founder is concerned about personal liability protection 16
  17. 17. Organizing an entity “too late”• Many founders wait to formally “incorporate” (or organize a non-corporate entity) until they are convinced that their “idea” will be viable/profitable – Waiting may be a mistake, as many aspects of business development prior to establishing “viability” will benefit from creating an entity – In a competitive industry, first mover advantages may be lost by waiting too long – Founders may be unaware of the risks of waiting • Liabilities arising before incorporation generally cannot be erased by subsequent incorporation 17
  18. 18. Possible business structures• When starting a business, one of the first questions that needs to be addressed is the question of which type of entity• Numerous alternative business structures exist, but the most relevant forms to consider are: – Sole proprietorship – Partnership – Limited Liability Company (LLC) – Corporation• The optimal business structure depends on the specific circumstances of the founder(s), the business plan and the entity itself 18
  19. 19. Reasons for organizing an entity• The reasons to organize an entity include: – Limit liability and protect personal assets – Accounting clarity and separation – Tax minimization and flexibility – Vehicle for external funding – Credibility with third parties – Multiple founder(s) or partner(s) – Enhance protection of intellectual property rights – Accommodate employees (and related compensation issues)• A more indirect advantage of entity creation is “the benefit of leading a tidy life” – the founder is forced to focus on structure, governance and documentation before problems arise 19
  20. 20. Criteria in selecting optimal business structure1 • Double taxation (taxation of both corporation and stockholder) versus Taxation pass-through treatment where the corporate entity is not taxed • Taxation on exit2 • Limitation of liability (up to value of equity contribution) versus Liability unlimited personal liability3 Administrative • Costs of entity organization and continued administration of entity costs4 Funding and • Accommodate funding and governance concerns governance considerations5 Retention of • Attract and retain key employees employees • Equity incentive compensation6 Retaining • Certain tax benefits from retaining earnings to fund business earnings 20
  21. 21. Snapshot: The role of accountants• As soon as expenditures are (or are expected to be) meaningful, an accountant with experience and interest in dealing with startups should be retained• More and more accountants are willing to accept modest, fixed or capped fees in the early stages of startups• However, some accountants will also advise on legal issues, including questions of organizational structure and documentation – The roles of the accountant and the lawyer are separate and should be respected 21
  22. 22. Sole proprietorship• An individual who owns a business which is not incorporated or organized as a separate legal entity is referred to as a “sole proprietor” and his/her business as a “sole proprietorship”• If you do nothing (to organize), you will be in effect a “sole proprietorship”• Only possible to use sole proprietorship when there is one owner (or, in some cases, a husband and wife) – Inappropriate form for a business with multiple founders, investors or partners 22
  23. 23. Sole proprietorship• The owner manages the business and is personally liable for all business debt and other obligations• General legal rules on contract, tort, etc. govern the sole proprietorship and no specific regulations apply• Cheap, easy and fast to “set up” and to maintain• No requirement to register an entity with state regulatory authorities• May require state and local regulatory compliance and/or business license• No governance agreements such as by-laws or stockholder agreements• The sole proprietorship and the owner are treated as one entity for tax purposes – the sole proprietorship cannot retain profits and avoid paying individual taxes• The business cannot be sold as an entity (as in the case of a corporation or an LLC) – the business can be sold in an asset sale 23
  24. 24. Partnership• A partnership is a business organization in which two or more individuals (partners) manage and operate the business• If two individuals start a business together and do not form a limited liability entity, chances are they will be found to be general partners doing business as a General Partnership• Two types of partnerships exist: – A General Partnership • the partners have unlimited liability – A Limited Partnership • the general partner(s) have unlimited liability • the limited partner(s) have limited liability• Because general partners have unlimited liability, the general partnership consisting of individuals is rarely used today• A partnership is a pass-through tax entity – Profit and losses are attributed to partners irrespective of whether distributions are made to partners 24
  25. 25. Limited Partnership• A Limited Partnership is a partnership with limited liability characteristics and pass- through tax treatment• Each state has a law authorizing and regulating Limited Partnerships• General Partner(s) are personally liable for business debts and liabilities – There must be at least one General Partner (with unlimited liability) in a Limited Partnership• Limited Partners do not generally have personal liability – Limited Partner(s) who control the business are personally liable 25
  26. 26. Limited Partnership Agreement• The limited partnership agreement deals with day-to-day management of the partnership, profit sharing and termination – Profits can be divided among the partners as desired by the partners – The General Partner(s) manage the business – Transferability of interests in a limited partnership may be restricted – Limited Partnerships are often assumed to be cheaper to maintain (since there are no formal requirements for minutes of meetings or for boards of directors or officers) • This can be a false assumption 26
  27. 27. Limited Liability Company (LLC) • Upside: so much flexibility • Downside: so much flexibility 27
  28. 28. Limited Liability Company (LLC)• An LLC is an “entity” which is not a corporation and which provides the benefits of limited liability and pass-through tax treatment – Limited liability depends on adherence to so-called formalities – Pass-through tax treatment can be “elected” away• All 50 states have passed legislation authorizing LLCs – These laws differ slightly, e.g. regarding which businesses can be conducted by an LLC and in the rules governing operation and maintenance of the entity• LLCs can be seen in some respects as more flexible than corporations – Especially in respect of management and capital structure• LLCs are generally disfavored by venture capital and offshore investors 28
  29. 29. Limited Liability Company (LLC)• LLCs are formed by submitting articles of organization to the appropriate state authorities• LLCs have limited liability; the owners of an LLC (“members”) have no personal liability (beyond value of membership/equity contribution) – Exception: piercing the “limited liability” veil • business affairs of LLC and members are entangled • the LLC does not comply with the required legal formalities, e.g. failure to keep proper records • the LLC is undercapitalized – Members of LLC startups are often required to guarantee loans made to the LLC• Members enter into an operating agreement governing the management of the LLC, distribution of profits, etc.• A benefit of the LLC structure is significant flexibility – An LLC can be structured to mimic a corporation or a partnership 29
  30. 30. Limited Liability Company (LLC)• The LLC is a pass-through tax entity (but it can elect to be taxed as a corporation)• Profits can be divided among the members irrespective of ownership percentages• The members can manage the LLC themselves or appoint separate managers• Managers are liable to the LLC and members in connection with the performance of their duties – indemnifications can be provided in operating agreement• Transferability of membership interests is governed by the operating agreement and securities laws and regulations• Incentivized compensation schemes may be more difficult to implement (than for corporations) – it is possible to offer employees membership interests but membership equity compensation may be awkward and unattractive 30
  31. 31. Snapshot: New York City UBT• New York Unincorporated Business Tax (UBT) applicable to all partnerships and LLCs in New York City (wherever organized) – UBT is charged to every individual or unincorporated entity carrying on trade, business or profession in New York City – UBT is 4% for taxable income allocated to New York City – LLCs that are not treated as corporations for tax purposes are required to pay UBT 31
  32. 32. Snapshot: New York LLC Publication Requirement• New York requires all domestic and foreign LLCs to publish a notice regarding the organization or application of authority, as the case may be – Deadline: within 120 days after effectiveness of the initial articles of organization or the filing to do business in New York, as appropriate – The notice shall contain certain specified information about the LLC – The notice shall be published once in each week for six successive weeks, in two newspapers of the county in which the office of the LLC is located • One newspaper shall be printed daily and the other newspaper shall be printed weekly – If the publication is not made, the authority of such LLC to carry on, conduct or transact any business in New York State shall be suspended – Costs to publish the notice varies depending on the county • Costs are estimated at between $ 200-300 (up-state New York) and $ 1,300 (Manhattan) 32
  33. 33. Corporation• A corporation is a separate legal entity, with limited liability, distinct from the stockholders, directors and officers – A corporation is said to be a “legal person”• All 50 states have distinct corporation laws – In general, corporations are taxable entities 33
  34. 34. Corporation• Corporations are formed by submitting articles of incorporation to the appropriate state agency• Corporations have limited liability; stockholders have no personal liability (beyond value of equity contribution) – Exception: piercing the corporate or “limited liability” veil • business affairs of corporation and stockholders are entangled • the corporation does not comply with the required legal formalities, e.g. failure to keep proper records • The corporation is undercapitalized – Stockholders of startup corporations are often required to guarantee loans made to the corporation• The rules of governance of a corporation are set forth in the corporation’s articles of incorporation, bylaws and stockholders’ agreement(s) 34
  35. 35. Corporation• A corporation is a taxable entity (and is not a pass-through tax entity)• Corporations are managed by a board of directors and officers – Limited flexibility of management/capital structure• Directors and officers are liable to the corporation and the stockholders in connection with the performance of their duties – indemnifications can be provided in governance documents• Stockholders can transfer shares unless such transfer is restricted by a stockholders’ agreement or securities laws and regulations• Incentivized compensation schemes generally thought to be easier to implement (than for LLCs) 35
  36. 36. “C Corporations” and “S Corporations”• C Corporations are subject to corporate income tax under the Internal Revenue Code (and most state tax laws)• S Corporations are pass-through entities not subject to corporate income tax under the Internal Revenue Code (and most state tax laws) 36
  37. 37. “C Corporations” and “S Corporations” C Corporation S Corporation• The “customary” form of corporate • S Corporations are “hybrids” between taxation partnerships and C Corporations• Double taxation • Pass-through tax treatment – Corporate income tax • S Corporation must allocate the taxable – Stockholder level (taxation of income to the stockholders in dividend income) accordance with their ownership stakes• Unlimited number of stockholders • Limitations on stockholders and stocks• The most popular business entity with – Stockholders must be US citizens or venture capital investors residents – Easiest to take public in an IPO – Maximum 100 stockholders – Easiest/cleanest business entity for – Stockholders must be individuals; equity incentives (e.g. stock options) limited exceptions for trusts, estates to attract and retain employees and exempt organizations – Limited to one class of stock 37
  38. 38. S Corporation Compliance• S corporation status requires affirmative election filed within short time period with consents signed by all stockholders• Risk of inadvertent termination of S Corporation election if: – a stockholder transfers shares to an ineligible individual or entity (e.g., an IRA) – a lender is given an "equity kicker" that is deemed to create a second class of stock – special allocations of profits or losses are made to some stockholder(s), which is deemed to create a second class of stock• Distribution of appreciated property by an S Corporation triggers taxation of gain to the S Corporation stockholders 38
  39. 39. Comparison of Costs: Delaware LLC and Corporation• The following costs are associated with formation and maintenance of “domestic” Delaware LLCs and corporations (which do business in New York):• LLC – Formation fee: $ 90 – Annual tax: $ 250 – Publication fee (in New York): $ 200 – 1,300 (est.) – Service agent: $ 100 - 300• Corporation – Incorporation fee: $ 89 (minimum)* – Annual report filing fee: $ 50 – Annual franchise tax: $ 75 or more (up to $ 180,000 maximum)* – Service agent: $ 100 – 300 * depends on value of assets and number of shares 39
  40. 40. Costs of Delaware Incorporation• Example: – A Delaware corporation having gross assets (as determined for federal tax purposes) of $ 1,000,000 and which has authorized 1,000,000 shares of common stock, par value $ 1.00 per share, and 250,000 shares of preferred stock, par value $ 5.00 per share, of which 485,000 total shares have been issued, would have an annual franchise tax payable of $ 1,400 – A leading service agent charges a fee of approx. $ 100 – 300 to act on behalf of an entity that does not have a place of business in the state 40
  41. 41. Comparison chart of business entities Sole LLC C Corporation S Corporation proprietorshipFormation None File and pay fee File and pay fee File and pay feerequirementManagement Owner Members or appointed Board and officers Board and officers managers (flexible)Limited No Yes Yes YesLiabilityTaxation Entity not taxed Pass-through - but Double taxation Pass-through can elect corporate taxFunding Sole proprietor Sale of interests Sale of stock – Sale of stock - provides capital subject to operating preferred form for limitations on agreement VCs investorsEquity Not possible Can require more work Easy and clean Possible but lessincentives than corporations flexible than C Corporation 41
  42. 42. Snapshot: Organizing without a lawyer• We have all seen startups that were organized without the assistance of a lawyer• The reasons for self-organization could be: – To save money – (False) belief that a lawyer isn’t necessary• There are many intricacies involved in organizing a specific form of entity and choosing the right form that serves the needs of a startup• Most self-organized entities contain significant flaws in organization or documentation that can expose the entity to life threatening" risks, including unresolved disagreements among founders, uncertain ownership of critical intellectual property, unexpected tax liabilities, inability to attract and retain employees, and inability to raise equity or debt capital• A dollar saved while organizing the business entity could be costly when external funding is needed to grow the business or the founders wish to exit• A professional investor will never invest in a company with a flawed corporate set-up 42
  43. 43. Snapshot: Organizing with a lawyer• Lawyers experienced in advising startups have template formation documents that can easily be fine-tuned to the circumstances of the specific business• Lawyers with experience with startup companies know the importance of an open and candid discussion about fees and are usually willing to negotiate cost effective solutions for the startup process• Cost effective solutions can include – Modest, fixed or capped fees in the early stages of startups – Equity compensation • Both pros and cons 43
  44. 44. Conclusion• The optimal business structure depends on the specific circumstances for the founder(s), the business plan and the entity itself• If the business is ready to attract venture capital investors or such funding is anticipated, incorporation as a C Corporation is generally thought to be preferable – Trend moving away from conventional wisdom?• Legal advice is very important to avoid organizing an entity as the wrong business form – mistakes in the organization process can be costly• Nevertheless, if the nature of a business’ prospects or goals changes, the form of organization can be changed by re-organization (merger) to a different form – Some changes will be more “expensive” than others; e.g. changing an LLC to a corporation is usually relatively straight-forward, while changing a corporation to an LLC is often more complex 44
  45. 45. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 45
  46. 46. Where to organize• You can organize in any of the 50 states and you do not need to be doing business in the state of organization – Thus, any state of organization can be chosen – Competition between states: Race to the top or race to the bottom?• Many states require that an entity which is organized in another state must qualify again as a “foreign corporation” in the state where it is actually doing business – Such qualification may subject the entity to additional taxes and fees – Example: a Delaware corporation which is “doing business” in New York would have to pay • $225 initially to qualify to do business in New York • an annual maintenance fee of $300 • $100 - 300 to a service agent (if the entity does not have a place of business in Delaware) • additional cost for LLCs: costs to make publication of the organization in New York newspapers 46
  47. 47. General considerations in choosing state• The following general considerations are significant when choosing the state of organization: – Incorporation, service agent and publication fees and franchise taxes – Level of corporate service – Signal effect and recognition factor – Predictability • Developed case law • Frequent updating of corporate statutes – Factors which are not generally relevant include: • geographical location of the business • Income tax rate of headquarters location 47
  48. 48. Where to organize • Delaware • New York • “The rest” 48
  49. 49. Popular states/places for organization• Popular states/places of organization include the following: – Delaware – New York – The home state – Others – Foreign incorporation• However, the applicable laws of all states or countries where the business is carried out apply and the entity – must qualify to do business in other states than the home state – can be sued in these jurisdictions – can conduct business in any jurisdiction (in which it is qualified) – generally must pay income, franchise or business tax in every jurisdiction where it conducts business 49
  50. 50. Delaware• Delaware has for many years been the preferred state of incorporation – Many venture capital and other investors insist on Delaware incorporation – Most lawyers prefer Delaware – More than 900,000 business entities have their legal home in Delaware • more than 50% of all U.S. publicly-traded companies • 86% of all IPOs in 2011 • 63% of the Fortune 500 are incorporated in Delaware• Delaware is the preferred incorporation state for companies seeking venture capital 50
  51. 51. Delaware• Smaller companies should consider whether the benefits of Delaware incorporation outweigh the disadvantages – Delaware may offer greater flexibility in governance than other jurisdictions – Lawyers are familiar with Delaware corporation law – There may be extra costs associated with an out-of-home-state incorporation, such as • required qualification to do business • New York requirement for LLCs to publish in newspapers that they do business in New York • requirement to have a service agent (if there is no place of business in the state) – Delaware has a franchise tax that is levied on its corporations• Reincorporating in Delaware to facilitate venture capital investments or an IPO can be more expensive than incorporating in Delaware from the start 51
  52. 52. Reasons to Choose Delaware 1. Delaware corporate law • business “friendly” • protection for officers and directors • flexible and modern statute 2. Delaware Court of Chancery • unique corporate law expertise • no counterpart in the other 49 states • service-minded and time-sensitive • experienced judges • extensive litigation results in predictability 3. State legislature • high priority on corporation law matters • Delaware Bar Ass’n recommends and drafts all amendments to the statute 4. Secretary of State • highly automated • sophisticated, efficient and service-oriented • long hours – office open after regular business hours 52
  53. 53. New York• New York organization may also be considered• New York has the following advantages: – New York corporate law is familiar to many lawyers and investors – New York is the home state for many professional investors – New York is an international center for financial services• But, the ten largest stockholders of private corporations organized in New York are liable for unpaid wages, salaries and other forms of compensation – Does not apply to foreign corporations that are qualified to do business in New York• New York is not nearly as widely used as Delaware for tech companies or companies with venture capital investors 53
  54. 54. Home state• If the entity is conducting business primarily in a single state (the home state of the founder), the home state may be the most logical state for incorporation – In the New York metropolitan area, Connecticut and New Jersey are sometimes used as organizational states for entities where venture capital or institutional investor participation is not anticipated• If the corporation does not do business in other states and is incorporated in the home state, the corporation does not need to be registered or qualified as a foreign corporation in other states – Thereby it avoids costs associated with having a service agent, qualification and, in the case of LLCs organized outside of New York, publication of the qualification• Home state incorporation may not be optimal if the entity plans to obtain venture capital funding at a later stage or if it is a candidate for an IPO 54
  55. 55. The Others• Nevada• California 55
  56. 56. Foreign incorporations• Foreign incorporation, for example in a tax-advantaged jurisdiction such as Cayman Islands or Bermuda, is unlikely to be attractive to a startup company or its US investors• However, foreign investors may require a non-US vehicle for tax reasons and certain IP and tax strategies may require use of a foreign corporation 56
  57. 57. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 57
  58. 58. Structuring Issues• Founders should confront and decide certain structuring issues at the time of entity formation• For corporations, these include – Corporate name and trade name – Classes of stock – Composition of board – Stockholder and board voting requirements – Titles and identities of officers 58
  59. 59. Structuring Issues• For LLCs, these include – Name – Legal provisions governing membership interests, including allocations and distributions to members (may not be pro rata) – Management and governance – Voting requirements 59
  60. 60. Snapshot: Naming Considerations• Is the corporate version of the name available in Delaware and the home state? – The entity can for a fee reserve a name while the organization process is ongoing• Does the name include required “words of limitation”?• Can the name be “trademark” and “trade name” protected?• Is someone else using the name in the same or a different industry?• Is the name available as a domain name? 60
  61. 61. Governance and transfer issues• If there is more than one founder, governance, transfer and exit issues will need to be decided as soon as possible• These include: – Voting rights and vetos – Tie-breakers – Buy-sell or other impasse provisions – Transfer restrictions – Exit rights (drag along and tag along)• Typically covered in a stockholders’ agreement and by-laws (corporation) or operating agreement (LLC) 61
  62. 62. Snapshot: The Deadlock Problem• Deadlock arises when directors or stockholders cannot resolve an impasse – most commonly when there is an evenly divided board or a tie vote among stockholders• There is no easy way to avoid deadlock unless you set up procedures in advance to deal with the problem – uneven number of directors – buy-sell provision – mediation/arbitration• Important to adopt deadlock breaking provisions early on – they are nearly impossible to adopt once a conflict has arisen 62
  63. 63. Initial Capitalization• After the structure is agreed, the founders will issue common stock (corporation) or membership interests (LLC) and must consider the relationship between equity percentage ownership and funding sources and requirements• Both common stock and membership interests represent a fractional undivided interest in the ownership of the entity• Valuation, class, preference, dilution and use of proceeds concerns must be addressed at the time of organization and each financing event – This topic will be discussed in greater detail in our next NYTECH program 63
  64. 64. Snapshot: Equity StructureFounders, employees, Board members and External Investors External Investors advisors Common Preferred Convertible Stock + Stock + Debt • Voting rights • Dividend preference • Debt convertible into • Options • Liquidation preference stock • Vesting • Voting rights • No voting rights • Equity to industry • Redemption rights experts and • Protective provisions celebrities? 64
  65. 65. Securities Law Compliance• The United States has very tough securities laws applicable to all sales of stock and other securities – The general rule is: No stock can be offered or sold unless registered or exempt from registration • Sales to employees, advisers, and investors (including friends and family) can be exempt so long as a specific exemption is identified and complied with – There are numerous different exemptions for private sales available, but an illegal sale can be difficult or virtually impossible to repair – There are civil and criminal penalties for violation of securities laws – While the recently-enacted JOBS Act liberalizes the securities law, it doesnt change some of the basic prohibitions – Always consult a lawyer before offering stock 65
  66. 66. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 66
  67. 67. Other considerations• When the business is being organized, or soon thereafter and for the life of the entity, the founders and investors will also need to consider other significant factors including: – Financing – Intellectual Property Rights• These will be the subjects of our next two classes 67
  68. 68. Financing: various stages and needs “Idea” Financing Organization Exit of startup company Lifespan of FinancingFinancing a business Optimize potential Execution of idea/ And operate build prototype Implementation of Financing strategy/revenue stage Financing 68
  69. 69. Various types of financing Self financing Family Venture Capital loan Financing Financing Considerations in seeking financing: Angel Family financing equity • Debt/equity • Founder vs. lender/investor • Retention of control • Bargaining power Bank loan • Economic needs of specific business • Timing - when to seek funding • Dilutive effects 69
  70. 70. Intellectual Property Rights• For many startup companies the most important element of the business is the people and the “ideas”• In order to commercialize the “idea” it is important that intellectual property rights be protected• The startup needs to make sure it is assigned/retains all intellectual property rights and it is entitled to sell and/or license such rights to third parties – Agreements with employees – Agreements with consultants, etc. 70
  71. 71. Agenda Holland & Knight Preliminary considerations Choosing the business entity Where to incorporate Structuring considerations Other considerations Takeaways 71
  72. 72. Takeaways 1. When to organize as a business entity • There are several reasons why organizing as a business entity is prudent - Trigger event - Limit liability, tax efficiency, promote external funding, credibility with third parties, etc. 2. Choosing the optimal form of organization • The optimal business structure depends on the specific circumstances of the founder(s) and the entity itself • If the business is ready to attract venture capital investors or such funding is in the near future, incorporation as a C Corporation is generally thought to be preferable 3. “Incorporation” state • A business can be organized in any of the 50 states irrespective of whether it does business in the state • Delaware is the most used state of incorporation for companies seeking venture capital financing • The home state is popular for entities that only have a local presence and do not expect to seek venture capital 4. Structuring considerations • The founders must consider certain structuring issues in connection with organizing the business, including - Choice of name, classes of stock/interests, composition of board/management, voting requirements, etc. - Governance issues: voting requirements, deadlock solutions, transfer restrictions, exit rights, etc. 5. Retain legal counsel early • Legal counsel should be retained as early as possible to assist in - Picking and setting up the optimal business structure - Protecting the business going forward, including the intellectual property rights - Ensuring compliance with securities laws and regulations 72
  73. 73. A Motto for Startups Finis Origine Pendet* The beginning shapes the end*Motto of Phillips Academy, Andover, Massachusetts 73
  74. 74. Exit 74
  75. 75. Questions?www.hklaw.com
  76. 76. AcknowledgementsThanks to Søren Justesen of Copenhagen, Denmark, an international law clerk at the New York office of Holland & Knight, for his substantial assistance in preparing these slides Thanks to my partner, Marc Reisler, and to Erik Grimmelmann, Executive Director of the New York Technology Council, for encouraging our involvement in the Legal Essentials series Thanks to my co-panelists, Paul Ellis of the law firm of Paul Ellis Law Group LLC and Glen K. Westerback of the law firm Frankfurt Kurnit Klein & Selz, for their thoughtful review and comments
  77. 77. Thank You!www.hklaw.com
  78. 78. Frode Jensen 31 West 52nd Street New York, NY 10019 Tel 212.513.3462frode.jensen@hklaw.com
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