If you are ready to take the plunge and start your own venture, what should you do from a legal perspective to get it off the ground? As an entrepreneur you will have a many things to do, so a cheat sheet of the critical points before your attorney dazzles you with legal jargon is valuable. LawPivot co-founders Jay Mandal and Nitin Gupta, plus Yusuf Safdari, an attorney providing advice to companies on LawPivot, compiled this list of five critical legal issues to consider when you start a company:
1. What kind of legal entity
It is easy to get overwhelmed by the number of entities out there, including “S” corporations, “C” corporations, limited liability partnerships, general partnerships, and many others. However, many general entrepreneurs (as opposed to entrepreneurs starting professional practices such as doctors and lawyers) soon narrow their focus on “S” corporations, “C” corporations and limited liability companies (LLC) as providing the optimum mix of protection against liability and a known body of law (translating into predictability) around how they function.
Another key issue is tax efficiency of the corporate vehicle. An “S” corporation and an LLC generally only attract one level of taxation—at the stockholder level. A “C” corporation is taxed as an entity in addition to taxation at the shareholder level. But, an “S” corporation has restrictions such as not allowing multiple classes of stock, a limit on the number of shareholders and an inability to have a corporate stockholder.
If you are going to have investors, an “S” corporation may not be optimal. LLCs are tax efficient also, but structuring them is complicated precisely because of the flexibility that is permitted. In addition, many investors prefer to invest in good old “C” corporations because they are widely understood and have a robust structure, e.g., you can IPO a “C” corporation. Therefore, a “C” corporation might be a good choice if you plan to have investors and want the maximum scope to do a lot of different things with the company.
2. Where to incorporate
In the United States, you can incorporate your company in any number of different states. The corporate laws of the jurisdiction in which you incorporate will be the set of rules that generally governs your company. Within the United States, it is logical to either incorporate in the state in which your main operations exist or in a state such as Delaware, which makes a business out of serving as a jurisdiction of incorporation for many companies.
The vast majority of public companies tend to be incorporated in Delaware. Accordingly, Delaware corporations come with a certain prestige. In addition, Delaware offers a well-oiled administrative framework and well-defined corporate laws that tend to favor management by offering flexibility in governing a company and a wide scope of potential indemnification against liability for officers and directors. However, if you incorporate in Delaware, but your company is “doing business” in another state then you will have to “qualify” to do business in that state also.
By “qualifying” to do business in another state, you will become subject to that state’s annual franchise tax (the annual cost of keeping a company in good standing in a state) that can run the range between nominal to significant in terms of cost. Many entrepreneurs will simply choose to incorporate in the state where their main business is headquartered. Although this may keep it simple and less costly, many states are slow to process corporate changes and have corporate laws that can be burdensome to comply with for management and stockholders and that may not be well-defined.
If you can afford the incremental cost, Delaware might be the way to go. You may also want to consider whether an offshore parent company structure is appropriate. Although the analysis can be complex, incorporating your company in an offshore tax haven such as the Cayman Islands or another jurisdiction can generate tax savings for particular types of businesses, particularly those with non-US. revenues.
3. How to structure the ownership
The equity (including stock and options) of your company can be owned in different forms and subject to different conditions. The simplest way to structure the ownership of your company is to give out fully-vested shares of stock in exchange for a purchase price. However, this approach certainly does not work for every company and every situation.
If you plan to obtain outside financing for your company, you will likely want to subject the stock or options to time-based or milestone-based vesting considerations. The notion is that common stock or options in a new company are typically understood to be earned through “sweat equity” because they are usually sold at a nominal or near nominal price to starving entrepreneurs or the starving employees of the company.
In addition, subjecting the stock or options to vesting can address founders or employees who leave before they have “earned” their equity. You should (or have your lawyers) keep careful track of all equity records and documents. Equity disputes are costly and distracting and can derail an equity financing or an exit of your company. You should also take the time and make the effort to understand how option plans work. While founders and certain executives may receive common stock, employees, consultants and advisers will often own options which represent a right to purchase stock at a fixed price for a certain period of time.
Unlike a stockholder, an option holder does not have to put out cash to purchase the shares until he or she is ready to do so and can sometimes wait until an exit of the company is about to occur (making the exercise of the option a sure bet!). Investors will typical invest in a “preferred stock” that has special rights which benefit investors and justify a difference in price between common and preferred shares (such that you can keep common shares affordable for employees and consultants while selling a different unit of ownership at a different price to your investors)
4. How to protect intellectual property
Almost every company has intellectual property which create and store value of the company. This intellectual property can consist of patents, trademarks, copyrights, trade secrets and domain names. What will be the “secret sauce” that differentiates your products or services from the competition? Finding a way to protect these intellectual property rights early may be critical to the enduring value of your company.
Even if your company has a minimal technology component, your “brand” may have strong market value. In addition, the return on investment can be substantial because some of these protections are relatively inexpensive to put in place relative to their potential value to your company. Each of the different types of intellectual property rights has different rules and different protections.
Patents may be somewhat expensive and demand a good bit of time with an attorney to prosecute, but the power to block others from practicing your invention can provide you an amazing competitive advantage for a long period of time. Copyrights and trademarks can prevent competitors from unfairly riding your coattails to earn profits likely at your expense. A proper trade secret program can protect a key formula (for example, Coca Cola) or a manufacturing process for a long time.
A solid portfolio of intellectual property rights can build and secure value in your company. If you do not protect some of these rights early, you are in danger of potential losing them or only having diminished rights. From the beginning of your company, every employee, consultant and advisor should sign an agreement which assigns the intellectual property that they develop to the company. Investors and acquirers will demand to see these agreements to confirm that all relevant intellectual property is owned by the company.
5. Why you should document every relationship
With hyper busy entrepreneurs and a non-stop, always-on society, it is easy to transact a lot of business informally. However, there is no substitute for properly documenting critical relationships with all the different stakeholders, vendors, customers and other people or entities that you need to deal with while building your business.
A lot of time is spent in the legal business cleaning up relationships that were poorly designed and documented. But an ounce of prevention is worth a pound of cure. There is pretty much a legal contract in existence for every type of relationship out there in the business world.
Being prepared with the right documentation can save you a good deal of pain, especially if things go south. In addition, a clear definition of obligations, rights and assumptions can help you and others understand what will happen in the event that certain contingencies or conditions arise out there. Obtaining a well-drafted legal contract or consulting with your attorney prior to negotiating or entering into a relationship is a good practice to develop even from the inception of your company.
Paying attention to these five issues should provide you with a running start in planning for the successful legal formation and structuring of your new venture. Don’t try to save a few bucks by not seeking good legal advice in these areas. The benefits of sound legal decisions when you start your company can help you avoid significant costs, damage, and lost opportunities later.