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Legal Stuff Entrepreneurs Should Know
- 1. Legal Stuff Every Entrepreneur Should Know Benjamin M. Hron McCarter & English, LLP 265 Franklin Street Boston, MA 02110 bhron@mccarter.com @HronEsq
- 2. Overview Organization Governance Equity Capital Structures Valuation Taxes Intellectual Property Employees Contractors B2B Contracts Questions
- 4. Types of Legal Entities Partnership Limited Partnership Limited Liability Partnership Corporation – C-Corporation – S-Corporation Limited Liability Company
- 5. Types of Legal Entities Partnership Limited Partnership Limited Liability Partnership Corporation – C-Corporation – S-Corporation Limited Liability Company
- 6. Organization Documents Corporations – Charter (aka Certificate/Articles of Incorporation) Filed with state to create corporation Defines types and amounts of equity authorized Establishes rights of each type of equity – Bylaws Governance Structure Other mundane details (ex. fiscal year) Typically track corporate statute
- 7. Organization Documents Limited Liability Companies – Charter (aka Certificate/Articles of Organization) Name and limited detail about entity No info about type or rights of equity – Operating Agreement Defines types, amounts and rights of equity Governance structure Usually includes complex tax provisions Little mandated by statute, so lots of variation
- 8. Governance Structure Corporations – Owners = Stockholders/Shareholders – Stockholders elect Directors – Directors appoint and oversee officers – Officers run day-to-day operations Limited Liability Companies – Owners = Members – May be “managed” by Members or Managers – May also have officers, but not required
- 9. Equity Capital Structure
- 10. Corporations Stock – Common: share of value of the company Sometimes subject to vesting (i.e. “restricted”) – Preferred has special rights/privileges Options to purchase stock – Incentive Stock Options (ISOs) Can only be issued to employees Preferred tax treatment if conditions are met – Non-Qualified Stock Options (NQSOs)
- 11. Corporations Authorized, Issued and Outstanding Stock – Authorized Set in corporation’s charter Total that can be issued without amending charter Fees typically increase with # of authorized shares – Issued: shares corporation has sold/granted – Outstanding: shares issued and not repurchased – Authorized stock not outstanding has no rights Vested v. Exercisable Options Vested = all rights have matured Exercisable = able to be exercised for stock
- 12. LLCs Ownership Interests Generally – Set in operating agreement, not charter – No impact on state fees – Can be unlimited Capital Interest v. Profits Interest – Capital Interest: share of value of the company – Profits Interest: share of profits from given date Used as incentive compensation Somewhat equivalent to options … but not really
- 13. Fully Diluted Capital Overall capital with claim on company’s assets Typically Includes: – outstanding stock (as-if-converted to common) – outstanding derivative securities (as-if-converted to common) (ex. options, warrants) – shares underlying options reserved for issuance Does NOT include authorized shares of common stock not outstanding or reserved Broad v. Narrow
- 14. Fully Diluted Capital Pop Quiz: What is FDC of company with… – 1M shares of Common Stock outstanding – 300K shares of Preferred Stock outstanding that convert to Common Stock 1:1 – Options to purchase 200K shares of Common Stock reserved for issuance, of which 100K options are outstanding, but not vested 50K are vested and exercisable – $500K of convertible debt with a conversion cap of $5M
- 15. Fully Diluted Capital Answer: – Narrow FDC 1M Common + 300K Preferred + 50K options vested and exercisable = 1,350,000 Common – Middle of the Road Add 100K options outstanding, but not vested and exercisable = 1,450,000 Common – Broad Add 50K options reserved = 1,500,000 Common – Very Broad Add Convertible Debt, but at what $?
- 16. Vesting Sets limitations on rights of stockholder: – For period of time; or – Until occurrence of specified event (milestone) Stock not yet vested can be repurchased … – If stockholder’s service ends – Upon occurrence of certain events (ex. acquisition) Vesting may accelerate upon – Acquisition – Termination of service in certain circumstances
- 17. Splitting Equity Even split usually isn’t the right answer Key factors to consider – Time invested and commitment going forward – Role in the company – Contribution of IP, cash or other assets Require most/all founders’ equity to vest – Time based: compensates for “time served” – Milestone base: compensates for achieving goals – Unvested equity is repurchased if founder leaves Split will usually change over time
- 18. Securities Laws Federal and State securities laws apply to every offer and sale of securities Securities must be “registered” or the securities or transaction must be exempt from registration Details of exemption dictate how and to whom securities can be offered and sold Penalty for failure to comply: purchaser of securities has right to get their money back
- 19. Valuation Taxes
- 20. How does valuation impact taxes? Recipient has taxable income on stock when issued = FMV – $ paid Options not taxed at grant if strike $ ≥ FMV – ISOs must be granted at or above FMV – NQSOs should be granted at or above FMV So options are the preferred form of equity incentive compensation – Recipient not required to pay for stock until it appreciates
- 21. Examples Ex. 1: Founder A contributes $10K for 50%; Founder B contributes “sweat equity” for 50% – Does Founder B have $10K of income? Ex. 2: Shortly after initial common stock issued to founders for $1 each, company raises $100K by selling 20% of common stock to investor – Do founders have $400K tax liability? Ex. 3: Company raises $3M through sale of Preferred Stock at $2M pre-money – What is strike price of options post-financing?
- 23. Types of IP Patents – cover inventions Copyrights – cover works of authorship, including software code Trademarks/Tradenames – cover identifying marks/names used in a trade or business Trade Secrets – cover proprietary information used in trade or business
- 24. Securing IP IP developed before organization of the company belongs to the creator if not assigned Contractors own their work product absent a “work for hire” agreement Employer owns work product of employees Require NDAs and Work-for-Hire agreements for everyone
- 26. Employees Contractors Different federal and state tests – MA test is very restrictive – No contracting around law Employees must receive: – minimum wage – overtime pay – workers comp Interns – nearly impossible to meet requirements Penalties are severe and enforcement authorities are “employee-friendly”
- 27. B2B Contracts
- 28. Key Elements Description of goods/services provided Timing on and conditions to payment Ownership of IP developed Non-competition, Non-solicitation Confidentiality Representations Warranties Covenants Indemnification/Limits on Liability Choice of Law/Forum
- 29. Key Elements Description of goods/services provided – Goods/Services should be clearly described – Specify timing of delivery – Set some sort of threshold for quality – Provide for remedy if goods/services aren’t delivered or don’t meet specifications
- 30. Key Elements Timing on and conditions to payment – If payment proceeds delivery, what is the remedy if goods/services are never delivered or don’t meet specifications? – If delivery proceeds delivery, what is consequence for late payment?
- 31. Key Elements Ownership of IP developed – If silent, party developing IP owns it. – Jointly-owned IP may not be controlled by anyone Patents – any owner can deal with freely; NO “duty to account” Copyrights – any owner can deal with freely but there IS “duty to account”
- 32. Key Elements Non-competition, Non-solicitation – Enforceability depends on scope – Non-competes hard to enforce Illegal in some states – Typically last 6-12 months after agreement ends
- 33. Key Elements Confidentiality – Make sure description of what is covered includes any type of proprietary information your company is going to disclose – Excluded from “Confidential Information”: Info in or that becomes part of the public domain Info received from 3rd party not under NDA Info independently developed by recipient – Exception from non-disclosure obligation where compelled by law
- 34. Key Elements Representations Warranties – Statements of fact true as of the date made – Bridge knowledge gap between parties – Want other sides RWs to cover information material to your decision to enter into the agreement that is much easier for them to provide than for you to determine independently Ex. Entering into an agreement with you will not breach any of their other contractual obligations.
- 35. Key Elements Covenants – Promises to do something in the future – Be sure you can perform on your covenants – Be sure the agreement includes necessary covenants for the other party
- 36. Key Elements Indemnification/Limits on Liability – Indemnification is the right to have someone else make you whole for an injury Should be tailored to circumstances Very complex body of law – Limits on Liability Typically eliminate liability for anything other than direct damages (i.e. no “indirect” damages) Usually excludes indemnification obligations and breaches of NDA or IP ownership obligations Mutual?
- 37. Key Elements Choice of Law/Forum – Determines how agreement will be interpreted – Determines where disputes will be settled – Usually determined by relative bargaining power of parties – Consider how choice of forum will impact your costs if you need to enforce the agreement
- 38. Questions? Benjamin M. Hron McCarter English, LLP 265 Franklin Street Boston, MA 02110 bhron@mccarter.com @HronEsq