Founders are a special breed — independent, self-reliant, and resourceful. Yet these same attributes, critical in taking an idea from zero to one, can eventually cause first-time founders to misjudge situations and tackle problems without appropriate guidance. This is particularly true (sometimes tragically so) in the legal arena, where founders generally have little or no experience and the risks are difficult to quantify.
To solve this, Extra Crunch is offering up well-sourced lists of the best lawyers for startups, alongside articles and resources written by experts who navigate tricky legal issues for startups on a daily basis. This article is the first of a five-part series covering the legal terrain you should endeavor to navigate with the help of an experienced guide, including:- Corporate: Business Formation, Capitalization and Financing, Securities and Options, etc.
- Intellectual Property: Patents, Trade Secrets, Trademarks, and Copyright, etc.
- Business Transactions: Master Services / SaaS Agreements, Terms of Use, NDAs, etc.
- Compliance and Regulatory: Business Qualification, Privacy, and FTC Regulation, etc.
- Human Resources: Employee Compensation, Contractors, Discrimination, Immigration, etc.
Threshold matters: Pre-existing IP and trademarks
Although technically not matters of corporate law, two threshold items relating to intellectual property should be mentioned form the outset. First, make sure you understand whether the intellectual property you are creating is subject to any claims from the prior or existing employers of the founders. We’ll discuss this topic further in a later article, but it is worth mentioning now so it is on your radar. Second, because your startup will need to brand itself to attract customers and/or users, put some effort in on the front end to make sure your business name is available and it will not result in trademark disputes down the road. This is easy enough to do using the USPTO’s trademark database, for example, but ultimately it could be a state-by-state question.Entity selection and incorporation – C corp/S corp/LLC
While many types of legal business structures exist, assuming you are interested in starting a high-growth technology company, really only two matter: the corporation and the limited liability company, or “LLC.” Each allows for multiple individuals to share in the ownership of the company and most of the time will shield owners’ personal assets from the obligations of the business — that is, unless otherwise agreed by the owners themselves, or due to some malfeasance of the owners (such as mixing personal and business expenses, something which founders have been known to do unfortunately). In the latter case, where a business owner’s personal assets can be held to account for liabilities of the company, courts have creatively termed this “piercing the corporate veil.” For startups ultimately looking to pursue a traditional VC route, incorporating in Delaware as a C corp is the obvious choice — there is no reason to overthink it. Under your certificate of incorporation (sometimes called a “charter”), you’ll typically want to authorize 10 million shares of stock at a “par value” price of $0.00001. (“Par value” is simply the lowest price at which a corporation may issue shares upon initial offering.) Of these 10 million “authorized” shares, only about 4-6 million shares of common stock are typically “issued” to founders from the outset (and don’t worry, percentage ownership is calculated based only on the issued shares). This will leave available additional “authorized but unissued” shares which can later be issued to create a stock option pool for incentivizing employees, or issued as preferred stock to investors in exchange for cash. With respect to the latter use specifically, it is generally not necessary to specifically authorize a separate class of preferred stock upon initial formation — this can always be done by amending the charter in connection with the actual investment round later on, since the round is likely to require a charter amendment in any case. One final note on initial formation: more recently, a new class of stock called “Series FF Stock” is sometimes included during initial formation for issuance to founders (essentially, a hybrid of common and preferred stock) in order to later facilitate stock sales by the founders themselves to investors in future equity financings, effectively allowing founders to personally realize some liquidity before an actual sale or IPO. If this sounds appealing to you as a founder, which it should, it is definitely worth asking your lawyer about. If you are not looking at a traditional VC path, however, S corps and LLCs can provide better options in certain situations, particularly if your business will remain relatively small over the long term (tens of employees and not hundreds). In terms of tax treatment, these entities are typically advantageous, especially in the early years, since business income and losses are “passed through” to the owners and taxed on an individual basis using Schedule K-1, with no separate layer of tax liability for the company itself. Also, in states like Delaware, California, and others that allow for “statutory conversion,” LLCs can relatively easily convert to a C corp later down the road, should the need arise, through a tax-free transaction under Internal Revenue Code Section 351; provided, however, that the operating agreement is initially well-drafted to anticipate this event (for example, using “membership units” rather than simple percentages to indicate the ownership interests of members). Finally, if you incorporate outside the state where you will be primarily running the business, you will also need to “qualify as a foreign entity” in your home state (in this case, “foreign” means different state, not country). Put differently, you will need to register your “foreign” company with the state where you are primarily “transacting business” and perhaps your specific county too depending on the nature of your business and any required business licenses. In both cases, the process is very simple (see, for example, New York and California) and most of the time a lawyer is not truly required here, but many, many founders just skip this step entirely, creating problems later on.Corporate governance
From a high level, a corporation is owned by the shareholders, who in turn have the power to elect individuals to the Board of Directors. The “Directors” govern the corporation on important matters outside the “ordinary course of business” and have the power to elect (and remove) the “Officers” of the corporation, who are responsible for day-to-day management of the business. The following offices must generally be filled right from the start: President (often the CEO), Treasurer (often the CFO or COO), and Secretary. That said, all three offices can usually be filled by the same person; for example, in California and Delaware both, a corporation may have only a single shareholder and Director. In California, however, once a corporation has two shareholders, it must have at least two board members, and once it has three shareholders or more, it must have at least three board members. Corporations must also typically hold certain required meetings wherein formal minutes are recorded, including in most states at least one annual meeting of the Board of Directors and one annual meeting of the Stockholders (or written consents in lieu thereof). Since the Board of Directors is the governing body of a corporation, a shareholder owning even a majority of the shares can be outvoted at the Board level with respect to important governing matters (e.g., sales of additional stock or election/removal of officers). Shareholders can remove Directors, of course, but this is a relatively drastic move, so selecting those who will occupy seats on the Board of Directors is extremely important for founders. In the beginning, the Board of Directors should only include founders and ideally an odd number of them to avoid voting deadlock on important company decisions. If you must have an even number of Directors on the Board, e.g., two 50/50 co-founders, then at least make sure you’ve included specific “tie-breaker” provisions in the governing documents of the company.Now, once the “certificate of incorporation” (or “charter”) is filed with the Secretary of State, the initial Directors of the company will be formally appointed by a written document called the “Initial Action by the Sole Incorporator” (often company counsel will perform this action). The initial Directors will then elect the Officers, authorize and issue stock to the founders, authorize the opening of a business bank account including establishing a federal Employment Identification Number (EIN), and paying expenses, etc. All of this is generally done through a “unanimous written consent” of the Board of Directors, which is a document signed by all Directors, rather than through votes taken in a formal in-person organizational meeting. Other matters often addressed through this first “unanimous written consent” may include adoption of the following:- Bylaws, which set out board election and voting procedures;
- Restricted Stock Purchase Agreement, which imposes “vesting” and rights of first refusal on founder/employee stock, as well as an assignment of pre-existing intellectual property to the company in certain cases;
- Equity Incentive Plan (i.e., stock option plan), which sets forth the terms on which stock options can be granted and exercised;
- Proprietary Information and Invention Assignment Agreement (PIIA), which will be signed by all founders, employees, and consultants, assigning to the company ownership of all intellectual property created in the business;
- Selection of applicable fiscal year; and
- Election of S Corp tax treatment (if desired).
Issuing “founder stock” at initial formation
“Founders Stock” is simply the common stock issued to founders when a corporation is initially formed; if done correctly, it is non-taxable because: (1) it is equal in value to the small amount of cash founders pay into the company in exchange for receiving the stock at par value (another good reason to set the par value very low, again say, $0.00001, allowing for minimal cash outlay); or (2) “property” has been contributed to the company in exchange for the stock under Section 351 of the Internal Revenue Code, which provides that no gain or loss is recognized if property is transferred to a corporation by a person or persons who together own at least 80% of the corporation. “Property” has been broadly defined to include legally protectable know-how and trade secrets, but this definition is not infinite in scope, so don’t get carried away trying to avoid paying the par value price for the stock in cash. Instead, one recommended hybrid approach involves each founder paying a portion of the par value purchase price of their stock to the company in cash, with the remainder covered by or attributable to an assignment by each founder to the company of their pre-existing intellectual property. This approach covers all the bases in terms of valid consideration (i.e., the cash payment) while ensuring that the pre-existing intellectual property of each founder is properly owned by the company.Founder vesting and section 83(b) within 30 days
Where co-founders have contributed cash or other property to the company in exchange for their shares at par value, they own the stock outright. Thus, to achieve vesting and protect all founders from any particular co-founder leaving early with a large chunk of the company, each founder should enter a “Restricted Stock Purchase Agreement” (directly with the company), which gives the company the right to buy back that founder’s shares, often at par value. This right gradually lapses over time with respect to more and more of the founder’s shares, creating the effect of vesting for those shares no longer subject to the company’s repurchase right. For co-founders involved immediately upon initial formation, you could reasonably argue that a “cliff” is not necessarily required, but the typical vesting schedule is 4 years, with 25% of the total shares vesting after the first year in a single chunk (this first year representing the “cliff” since nothing will vest if this one-year mark is not reached) then monthly vesting thereafter. Founders should also be aware of single and double-trigger acceleration provisions, which typically become more relevant once institutional investors are involved — more on that via Cooley Go. Once the Restricted Stock Purchase Agreement is signed, however, certain tax implications are raised, because technically the founder’s stock is now at a “substantial risk of forfeiture” (since founders might forfeit stock if they leave the company). This means that by the time the stock actually “vests” it will almost certainly be worth more than the par value for which it was purchased. The IRS will want taxes paid on that delta, since technically that increase in value is taxable gain. The solution? Internal Revenue Code Section 83(b), which allows founders and employees to elect treatment of non-vested shares as fully transferred at the very beginning of the vesting schedule, rather than over time as the shares vest. This allows for immediate taxation at the relatively lower current value, which in the case of a newly formed corporation is only some nominal amount based on the par value. This Section 83(b) election must be made in a written document actually signed and filed by the taxpayer within 30 days of the date the stock was made subject to restriction (or in the case of stock options, the date granted). While relatively simple to carry out, this process is important enough that getting oversight from experienced corporate counsel is prudent. See Holloway Guides for more discussion.Raising capital
Capitalization, accredited vs. non-accredited investors. “Capitalization” in the startup context generally means the funding necessary for a startup to open for business, while “capital structure” refers to the types of capital (broadly, either equity or debt) available to fund business operations. Capital structure often consists of common stock and preferred stock (equity), as well as convertible notes (debt). A “capitalization table” (or “cap table”) will provide a summary of all securities (stock) issued by the company, along with the fully diluted percentage ownership of each shareholder based on all issued shares (not the total authorized shares). Capitalization of your startup may include issuance of convertible notes or the sale of preferred stock and other securities, all of which are subject to the federal “Securities Act of 1933” as well as various “Blue Sky” state laws, essentially intended to prevent fraudsters from selling shares in worthless companies to unwitting investors. In determining compliance with these laws, the distinction between ‘Accredited’ and ‘Non-Accredited’ investors is important; in brief, raising money from accredited investors generally means there is less to worry about. “Accredited Investors” by definition must have net worth of $1 million (excluding a principal residence) or annual income for the current and past two years of at least $200,000 (or $300,000 jointly with a spouse). If you are planning on raising money from Non-Accredited Investors, which founders should NOT do but often will do anyway, then in addition to familiarizing yourself with Rule 502(b)(1) and related Rules 504-506 of Regulation D (which provide relevant exemptions in this context), you should absolutely consult with an experienced securities attorney to make sure your reliance on these rules is not misplaced, as they are deceptively complex, though essentially can be summarized as follows:- Rule 504 provides an exemption for the sale of up to $1 million in securities within any 12 month period;
- Rule 505 provides an exemption for the sale of up to $5 million in securities within any 12 month period to any number of accredited investors and up to 35 unaccredited investors; and
- Rule 506 provides an exemption to an unlimited number of accredited investors and up to 35 other purchases, provided, however, that all non-accredited investors are “sophisticated” — having sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
- Valuation/Dilution (pre/post-money)
- Dividend preferences;
- Redemption rights;
- Conversion rights;
- Anti-dilution protections (in order of most to least founder-friendly: “weighted average — broad based,” “weighted average – narrow based,” or “ratchet based”);
- Voting rights (election of “x” number of members to the Board of Directors, approval of a sale or merger, issuing more shares, etc);
- Registration rights;
- Protective provisions, which can include certain affirmative covenants (e.g., investor access to financial information of the company) and certain negative covenants (e.g., agreement not to take certain actions without approval of the preferred shareholders)
- Right of first refusal; and
- Co-sale rights.