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

Legal Essentials for Startups:
Part 1 of 3 – Organizing the Entity

Frode Jensen
October 25, 2012
1375 Broadway, New York, NY

Disclaimer

The materials and information contained in this presentation are presented for informational
purposes only and do not constitute advertising, solicitation or legal advice. Although care
has been taken to ensure that the materials are correct, complete and up-to-date, the
presenters and their firms assume no responsibility therefor. Accordingly, you should not
act or rely on any information in this program without seeking the advice of an attorney
licensed to practice law in your jurisdiction.

The materials contained in this presentation do not create and are not intended to create an
attorney-client relationship between you and any of the presenters, Holland & Knight LLP,
Paul Ellis Law Group LLC or Frankfurt Kurnit Klein & Selz.

2

Agenda

Holland & Knight

Preliminary considerations

Choosing the business entity

Where to incorporate

Structuring considerations

Other considerations

Takeaways

3

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

Holland & Knight Offices

Portland

Boston

Chicago
New York

San Francisco Washington, D.C.
Northern Virginia

Los Angeles Atlanta

Tallahassee Jacksonville

Orlando
West Palm Beach
Tampa Fort Lauderdale
International Offices
Lakeland Miami
Abu Dhabi, United Arab Emirates
Beijing, China
Bogotá, Colombia
Mexico City, Mexico

5

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 Admission
Partner • Venture Capital & • Williams College, B.A. • New York
Holland & Knight, LLP Private Equity • Columbia University • Connecticut
212.513.3462 • Corporate Law School, J.D.
Governance
frode.jensen@hklaw.com
• Mergers & Acquisition
www.hklaw.com • Financial Services

7

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 Admission
Associate • Corporate and • The College of William • New York
Frankfurt Kurnit Klein & Selz Finance & Mary, B.A.
212.826.5563 • Technology, • Cornell Law School,
eCommerce and J.D.
gwesterback@fkks.com Privacy
www.fkks.com

8

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 Admission
Managing Member • General Corporate/ • Harvard University, • New York
Paul Ellis Law Group LLC Contracts B.A.
212.949.5900 • Financing/Venture • Georgetown University
Capital Law Center, J.D.
pellis@pelglaw.com
• Intellectual Property
www.pelglaw.com

9

Agenda

Holland & Knight






Takeaways

10

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

Agenda

Holland & Knight






Takeaways

12

South Park Plan: How Not to Start a Company

13

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

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

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

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

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

Criteria in selecting optimal business structure
1
• Double taxation (taxation of both corporation and stockholder) versus
Taxation pass-through treatment where the corporate entity is not taxed
• Taxation on exit
2
• Limitation of liability (up to value of equity contribution) versus
Liability unlimited personal liability

3
Administrative • Costs of entity organization and continued administration of entity
costs

4
Funding and • Accommodate funding and governance concerns
governance
considerations
5
Retention of • Attract and retain key employees
employees • Equity incentive compensation

6
Retaining • Certain tax benefits from retaining earnings to fund business
earnings

20

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

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

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

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

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

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

Limited Liability Company (LLC)

• Upside: so much flexibility

• Downside: so much flexibility

27


• 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


• 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


• 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

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

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

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

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

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

“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

“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

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

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

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

Comparison chart of business entities
Sole LLC C Corporation S Corporation
proprietorship

Formation None File and pay fee File and pay fee File and pay fee
requirement

Management Owner Members or appointed Board and officers Board and officers
managers (flexible)

Limited No Yes Yes Yes
Liability

Taxation Entity not taxed Pass-through - but Double taxation Pass-through
can elect corporate tax

Funding Sole proprietor Sale of interests Sale of stock – Sale of stock -
provides capital subject to operating preferred form for limitations on
agreement VCs investors

Equity Not possible Can require more work Easy and clean Possible but less
incentives than corporations flexible than C
Corporation

41

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

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

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

Agenda

Holland & Knight






Takeaways

45

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

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

Where to organize

• Delaware

• New York

• “The rest”

48

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

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

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

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

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

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

The Others

• Nevada

• California

55

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

Agenda

Holland & Knight






Takeaways

57

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

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

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

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

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

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

Snapshot: Equity Structure

Founders, 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

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 doesn't change
some of the basic prohibitions
– Always consult a lawyer before offering stock

65

Agenda

Holland & Knight






Takeaways

66


• 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

Financing: various stages and needs

“Idea” Financing

Organization
Exit of startup
company

Lifespan of Financing
Financing a business

Optimize potential Execution of idea/
And operate build prototype

Implementation of
Financing strategy/revenue stage Financing

68

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

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

Agenda

Holland & Knight






Takeaways

71

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

A Motto for Startups

Finis Origine Pendet*

The beginning shapes the end

*Motto of Phillips Academy, Andover, Massachusetts

73

Acknowledgements
Thanks 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

Frode Jensen
31 West 52nd Street
New York, NY 10019
Tel 212.513.3462
frode.jensen@hklaw.com

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

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