Startup Law 101:How to Avoid Legal Pitfalls that Could Doom Your Startup

© 2020 Haynes and Boone, LLP
Thursday, December 28, 2023 9:00 AM PST
Startup Law 101:How to Avoid Legal Pitfalls that
Could Doom Your Startup
Roger Royse, Partner
Haynes and Boone, LLP
Palo Alto, CA

CLAIMS BY PRIOR EMPLOYERS
Avoid a prior employer’s claim to a company or its IP
California Labor Code § 2870 (attached)
 Employee’s Time
 No Employer Facilities
 Not Related to Employer’s Business
 Doesn’t Result from Work Performed for Employer
Best Practices
 CIAIA
 Representations by employee re former employer IP
 Avoid social media
2

THE IMPORTANCE OF DOCUMENTATION
Common Issues:
 Equity Ownership
 Loans or Contributions
 Vesting
 The Y-combinator Post Money SAFE
 Online Incorporators
Comments
 Dead on Arrival Issue
 Unsigned agreements are not agreements, but notes and emails may
evidence agreement if relied on
 Napkins as agreements
3

VESTING RESTRICTIONS
It's generally a good idea for founders to agree to vesting restrictions.
 Founder Vesting; Resetting the vesting schedule
 Single vs. Double Trigger
 Advisor Vesting
 The case of Zipcar
Tax
 83(b) election. When and who files? Can a late filing be fixed?
 Vesting Imposed on Financing
 Vesting Imposed on M&A
4

TAX PLANNING
 Choice of Entity (C Corp, S Corp, LLC)
 QSBS
 LLC Conversions
 State Tax Planning
 Foreign founders and inbound flips and migrations
 FinCEN Report and Corporate Transparency Act Compliance
5

LLC (not taxed as
corp)
S Corporation C Corporation
Entity Level
Federal Income
Taxes
No federal tax at LLC level.
Owners may qualify for a 20%
Sec 199A deduction.
Generally no tax at S
corporation level; some
excise taxes, and built in
gains taxes may apply.
Owners may qualify for a
20% Sec 199A deduction.
Income tax on earnings at
corporate level.
Eligibility
Requirements of
Owners and Equity
No restrictions. US citizens or resident
individuals, certain trusts,
and certain tax exempt
entities. 100 max (generally).
One class of stock limitation.
No restrictions.
Entity Level
California Taxes
Gross receipts fee, unlike state
law partnerships. $800
minimum.
Minimum franchise tax of
$800 or 1.5% taxable
income.
8.84% corporate rate
applies, or $800 minimum
franchise tax.
Option Plans,
NSOs, ISOs
Options on LLC interests are
complex and cause §704(b)
challenges. ISOs not
available, but profits interests
generally superior to ISO.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.
Choice of Entity (Assuming Domestic Entity)
6

LLC (not taxed as corp) S Corporation C Corporation
Status Change on
Transfer of Interests
If taxed as partnership, LLC
terminates for tax purposes on
transfer of 50% or more of capital and
profits in 12 months.
Can convert between DRE and
partnership on transfer
No termination of entity on
transfer of interests, except for
election termination on transfer
to ineligible shareholder.
No termination of entity on
transfer of interests.
Treatment of
Foreign Owners
Foreign members subject to US tax
on their share of effectively connected
income of LLC; branch profits tax may
apply.
Foreigners cannot be
shareholders of S corporation.
Foreigners are subject to
withholding tax on dividends
from US corporation, subject to
treaty rate or exemption.
Foreign Individual
Owners - Transfer
Taxes
Unclear. N/A. Foreigners cannot be
shareholders of S corporation
(except in certain trusts).
Corporate stock may be gifted
tax free. U.S. corporate stock
will be part of taxable estate,
however.
Conversion to
Another Entity
May generally be incorporated tax
free.
Conversion between partnership and
DRE can cause tax (e.g., investment
company rules).
Can convert tax-free to C
corporation by revoking
election; likely to be taxed on
converting to LLC.
Can convert to S corporation
by making election (built in
gains tax may apply to later
dispositions of appreciated
property). Conversion to LLC
likely taxable.
Taxes on Sale or
Liquidation
One level of tax, generally capital gain
except for amount allocable to certain
assets.
“Flowthrough” of international tax
characteristics to foreign seller
(including ECI).
One level of tax on sale of
stock or assets, generally
capital gain on stock sale.
No 754 election, decreasing
desirability of stock sale to
buyer.
Potential double tax. Corporate
tax on sale of assets.
Shareholder level tax on sale
of stock or liquidation.
Sales by foreign shareholder
likely not U.S. taxed.
Choice of Entity (Assuming Domestic Entity)
7

C Corporation
(If Qualifying for QSBS)
• 21% corporate income tax
• 0% on shareholders if
qualifies for QSBS
• Subject to limitations ($10
million or 10 times the
taxpayer’s adjusted basis)
• Exit: QSBS not available in
asset sale (or, likely, deemed
asset sales)
Passthroughs
• Not subject to corporate
income tax
• Up to 37% on shareholders
• Exit: can choose between
stock v. asset sale
Choice of Entity - Qualified Small Business Stock
GENERAL REQUIREMENTS
 Original issue.
 Five-year holding period.
 100% post- Sept. 27, 2010.
 $50 million Gross Assets
Test.
 Active Business Test.
 No significant redemptions.
Note: California does not follow federal income tax treatment of QSBS under § 1202.
8

Choice of Entity – C Corp Better than Passthrough?
QSBS C-Corp S-Corp
Assets Assets
VS.
(From seller’s view)
Answer: Depends!
Compare QSBS tax savings
to S corp asset sale’s higher
pre-tax FMV
Tax Savings Favor QSBS
•0% rate for QSBS sold (unless gain exceeds
threshold)
•20% rate for capital assets from S corp (likely no
SECA, NIIT)
•37% rate on OI assets from S corp
•1.5% CA tax on net income
Pre-Tax FMV Favors S corp
•Buyer should pay extra to buy S corp assets; get
value of cost recovery
•Value of cost recovery can be high to buyer, if fast
rate, low future value discount
•S corporations generally have only one layer of tax
in asset sale, unless there are ordinary income or
BIG-tax assets
•CA S corp taxes qualify for PET credit (not
individual)
•Passthrough may qualify for a 20% Sec 199A
deduction
Note: California does not follow federal income tax treatment of QSBS under § 1202.
9

CALIFORNIA LABOR LAWS
Misclassification
 AB-5/ AB2257
 IRS + EDD
 Workers’ Compensation
 Class Action Lawsuits
 The case of Homejoy
 The Biden Plan (attached)
 2024 New CA Labor Laws
 Paid sick leave, absence for reproductive loss, workplace violence
 AB1076 – unlawful non competes
10

PROTECT IP
Protect your intellectual property from claims of ownership by employers,
employees, consultants and competitors
 PIAIA or CIAIA
 Broadly Drafted Invention Assignments
 Federal Defend Trade Secrets Act
 Provisional Patents
 Patent and trade secret strategies
11

Trade Secret
 Definitions of Trade Secret
 Defined broadly as
 Secret (formula, program, device, method, technique)
 Having independent economic value from not being generally known
 Is the subject of reasonable efforts to maintain its secrecy
 “All forms and types of financial, business, scientific, technical, economic,
or engineering information" that is kept secret and has reasonable
independent economic value 18 U.S.C. §1839(3)
12

Trade Secret vs Patent
Advantages of Trade Secret
1. Need not be non-obvious, can be non patentable
2. No government filing required
3. No disclosure
4. Can evolve (unlike patent filings)
5. Trade secrets last forever; patents 20 years
6. Can design around a patent but trade secret may extend to
improvements that derive from trade secret
Disadvantages
1. Trade secrets can be reverse engineered
2. Inadvertent disclosure loses protection
13

THE VALUE OF TRADEMARKS
 Trademark may be most valuable asset
 Research existing names and logos.
 Brand company strategically and legally.
14

IRC SECTION 409A
Section 409A of the Internal Revenue Code is an expensive gotcha’
409A Penalties: 20% plus tax and interest(plus state)
1. Stock Option Pricing
2. Deferred Salary
409A Requirements: Nonqualified Deferred Compensation
 Payable on separation from service, disability, death, fixed time or
schedule change of ownership or control, unforeseeable emergency
15

SECURITIES LAWS
Avoid the hefty consequences associated with state and federal
securities law violations.
 SAFES + Convertible Notes
 Blue Sky Filings
 Form D
 Potential criminal liability
 Recent fraud cases: FTX, Theranos, Nikola
 Fraud vs Puffing
 Crowdfunding: The Reg CF Problem
 ICOs, STOs, IEOs + Tokens
16

INVESTORS
THE (UN)SAFE
 Valuation Caps + SAFE = Unknown Dilution
 Pre–Money – SAFEs take dilution of other SAFEs
 Post-Money – SAFEs do not dilute for other SAFEs
SERIES SEED
 Watered down preferred stock
 Justifies low common stock price
VENTURE CAPITAL
 Expensive Money
 VC Fit
 Efficient market - NVCA Forms
17

Personal Liability
 Taxes
 Wages
 Fraud
 Fiduciary
 Securities
 Contract
18

CONTACT US
19
Roger Royse, Partner
Haynes and Boone, LLP
+1.650.687.8820
Roger.Royse@haynesboone.com

DEAD ON ARRIVAL BOOK
20
Dead on Arrival: How to Avoid the
Legal Mistakes That Could Kill Your
Start-Up.
This book outlines the legal mistakes
that start-up companies and their
lawyers make on their way to success
and how to avoid making those
mistakes. Some of those mistakes can
be rectified, but many will result in your
start-up company being Dead on
Arrival when it looks for financing or
acquisition opportunities. Knowing
what those mistakes are and how to
avoid them is essential to starting and
building a successful company. This
was published in 2012 and is available
in both print and audio formats.

10,000 Startups
21

23
Cal Labor Code 2870.
(a) Any provision in an employment agreement which provides that
an employee shall assign, or offer to assign, any of his or her rights
in an invention to his or her employer shall not apply to an invention
that the employee developed entirely on his or her own time without
using the employer’s equipment, supplies, facilities, or trade secret
information except for those inventions that either:
(1) Relate at the time of conception or reduction to practice of the
invention to the employer’s business, or actual or demonstrably
anticipated research or development of the employer; or
(2) Result from any work performed by the employee for the
employer.
(b) To the extent a provision in an employment agreement purports
to require an employee to assign an invention otherwise excluded
from being required to be assigned under subdivision (a), the
provision is against the public policy of this state and is
unenforceable.

THE BIDEN PLAN
“Ensure workers in the “gig economy” and beyond receive the legal
benefits and protections they deserve. Employer misclassification of “gig
economy” workers as independent contractors deprives these workers of legally
mandated benefits and protections. Employers in construction, service industries,
and other industries also misclassify millions of their employees as independent
contractors to reduce their labor costs at the expense of these workers. This
epidemic of misclassification is made possible by ambiguous legal tests that give
too much discretion to employers, too little protection to workers, and too little
direction to government agencies and courts. States like California have already
paved the way by adopting a clearer, simpler, and stronger three-prong “ABC
test” to distinguish employees from independent contractors. The ABC test will
mean many more workers will get the legal protections and benefits they rightfully
should receive. As president, Biden will work with Congress to establish a federal
standard modeled on the ABC test for all labor, employment, and tax laws.”
THE BIDEN PLAN FOR STRENGTHENING WORKER ORGANIZING,
COLLECTIVE BARGAINING, AND UNIONS

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Startup Law 101:How to Avoid Legal Pitfalls that Could Doom Your Startup