Here are ten essential legal tips for startup founders.
1. Set up your legal structure ahead of time and use cheap stocks to avoid tax problems.
No small business wants to invest heavily in legal infrastructure at an early stage. If you are a solo founder operating out of a garage, save your money and focus on development.
If you are a team of founders, it is important to establish a legal structure early on.
First, if your team members develop intellectual property, the lack of a structure means that each participant will have individual rights to the intellectual property they develop. The lead founder can warn this out by having everyone sign “work-for-hire” agreements assigning such rights to that founder, who in turn will assign them to the company once it is formed. How many enterprise teams do this. Almost nothing. Get the entity in place to capture the IP of the company as it develops.
Second, how do you bring a founding team together without a structure? You can, of course, but it’s awkward and you end up having to make promises that have to be taken on faith about what will or won’t be given to team members. On the flip side, many startups have been sued by a founder who claimed he was promised far more than he was given when the company was finally formed. As a team, don’t prepare for this kind of lawsuit. Set the structure early and write things down.
If you wait too long to set up your structure, you run into tax traps. Founders usually work for equality of work and equality of effort is a taxable good. If you wait until your first funding event before creating the structure, you give the IRS a measure by which to put a relatively large number on the value of your effort and subject the founders to undue tax risk. Avoid this by preparing early and using cheap stock to set things up for the founding team.
Finally, get a business attorney who specializes in your startup to help you or at least review your proposed setup. Do this early to help eliminate problems before they become serious. For example, many founders will moonlight while holding down full-time positions during the early startup phase. This often does not pose any particular problems. However, it does sometimes happen, especially if the IP address being developed overlaps with the IP the business owner holds for the overtime founder. Hire a lawyer to identify and address these issues early on. Arranging them later is more expensive.
2. Normally, go with a corporation rather than an LLC.
The limited liability company is a wonderful modern legal invention whose popularity stems from the fact that it has become, for individual entities (including husband and wife), the modern equivalent of a sole proprietorship with a limited liability cap on it.
When LLCs skip the sole member, you essentially have a partnership-style structure with a limited liability cap on it.
Partnership style structure does not lend itself well to the common characteristics of a startup. It’s a clumsy contraption for limited stock and for preferred stock. It does not support the use of incentive stock options. It cannot be used as an investment vehicle for VCs. There are special cases where an LLC makes sense for a startup but there are relatively few such companies (eg, where special tax provisions make sense, where only interest on earnings matters, where tax pass-through adds value). Work with an attorney to see if there is a special case. If not, go with a company.
3. Be careful about Delaware.
Delaware offers few, if any, advantages to getting started at an early stage. Many of the praises that business lawyers level for Delaware are justified for large public companies. For startups, Delaware often presents administrative inconveniences.
Some of the advantages of Delaware from an insider group’s point of view: (1) you can have a single director who makes up the entire board of directors regardless of the size and complexity of setting up the company, giving the dominant founder a way to keep everything close to his vest (if that’s desired); (2) you can dispense with cumulative voting, which gives leverage to insiders who want to prevent minority shareholders from gaining representation on the board; (3) You may arrange for the election of the members of the Board of Directors if you wish.
Delaware is also an effective state for doing corporate filings, as anyone frustrated by the delays and failures of some other government agency can attest.
On the downside – and this is a major one – Delaware allows preferred shareholders who control a majority of a company’s voting shares to sell or merge the company without the need for the approval of the common stock holders. This can easily lead to the downstream founder being “wiped out” by liquidation preferences held by the controlling shareholders.
Also on the downside, early-stage startups incur administrative hassles and additional costs with a Delaware setup. They still have to pay taxes on the income from their home states. They are required to qualify their Delaware corporation as a “foreign corporation” in their home states and pay the additional franchise fee associated with the process. They get tens of thousands of dollars in franchise tax bills and have to apply for an exemption under Delaware’s alternative assessment method. None of these elements is an overwhelming problem. Each one is an administrative hassle.
My advice from years of experience working with founders: keep it simple and skip Delaware unless there is a compelling reason to choose it; If there is a good reason, move to Delaware but don’t fool yourself into thinking you’ve been awarded a special prize for your early stage startup.
4. Use of restricted stock for the founders in most cases.
If the founder gets shares with no strings attached, and then walks away from the company, that founder will get an unexpected stock grant. There are special exceptions, but the rule for most founders should be to be granted restricted stock, that is, shares that can be bought back by the company at cost should the founder leave the company. Restricted stock lies at the heart of the Equal Effort concept for founders. Use it to make sure the founders get their profit.
5. Timely Elections 83 (b).
When restricted stock grants are given, they must always be accompanied by an 83(b) election to prevent potentially terrifying tax problems from eventually arising for the founders. This special tax option applies to cases where the shares are owned but can be forfeited. It must be done within 30 days of the grant date, signed by the stock recipient and spouse, and filed on the recipient’s tax return for that year.
6. Get technical assignments from everyone who helped develop the intellectual property.
When a startup is incorporated, equity awards should be made not only for cash contributions from the founders but also for technology assignments, as would apply to any founder who worked on intellectual property matters prior to incorporation. Do not leave these things on hold or allow shares to be issued to the founders without obtaining all of the company’s intellectual property rights.
Founders sometimes think they can keep the intellectual property in their hands and license it to a startup. this is not working. At least the company wouldn’t normally be bankable in such cases. Exceptions to this are rare.
The IP report should include not only the founders, but all consultants who worked on intellectual property matters prior to the company’s incorporation. Modern startups sometimes use development companies in places like India to help accelerate product development before the company is formed. If these companies are paid for this work, and if they do it under work-for-hire contracts, those who have a contract with them can assign to the emerging company the rights already obtained under the work-for-hire contracts. If there is no work-for-hire arrangement, you must be offered stock, a stock option or guarantee, or pay any other legal consideration to the outside company for the intellectual property rights you own.
The same is true of every contractor or friend who helped develop locally. Small option grants will ensure that intellectual property rights are rounded out from all interested parties. These grants shall be awarded in whole or in part to ensure that appropriate consideration is given to the IP assignment made by the Consultants.
7. Protect IP from now on.
Upon incorporation of the startup, all employees and contractors who continue to work for it must sign confidentiality agreements and invention assignment or work-for-hire contracts as applicable to ensure that all intellectual property remains with the company.
These people should also be properly paid for their efforts. If this is in the form of equity compensation, it must be accompanied by some form of monetary compensation as well to avoid tax problems arising from the IRS placing a high value on the stock using the reasonable value of the services as a measure of their value. If cash is an issue, payroll may be deferred as appropriate until first funding.
8. Consideration of provisional patent filings.
Many startups have an IP that will be largely lost or compromised once it is disclosed to others. In such cases, see a good patent attorney to determine a patent strategy for protecting that intellectual property. If appropriate, file provisional patents. Do this before disclosing key data to investors, etc.
If early disclosures must be made, do so incrementally and only under the terms of nondisclosure agreements. In cases where investors refuse to sign a nondisclosure agreement (for example, with venture capital firms), do not disclose your essential confidentiality clauses until you have the provisional patent on file.
9. Develop equity incentives.
With any true startup, equity incentives are the fuel that keeps the team going. When formed, adopt an equity incentive plan. These plans will give the board a host of incentives, including restricted stock, incentive stock options (ISOs), and nonqualified options (NQOs).
Restricted stock is usually used for founders and very key persons. ISOs are for employees only. NQOs may be used with any employee, consultant, board member, consulting director or other key person. Each of these tools has a different tax treatment. Use a good professional to advise you on this.
Of course, with all forms of stock and options, federal and state securities laws must be met. Hire a good lawyer to do this.
10. The company is increasingly funded.
Startups brimming with resources will use funding strategies in which they don’t necessarily seek significant venture capital funding immediately. Of course, some of the best startups have needed significant venture capital funding from the very beginning and have achieved tremendous success. However, most of them will face a problem if they need huge capital injections up front, and thus find themselves with few options if such financing is not available or if it is only available on oppressive terms.
The best results for founders come when they build significant value in the startup before needing to seek significant financing. The mitigating blow is much lower and they often get much better overall terms for their financing.
Conclusion
These tips suggest important legal elements that founders should consider in their broader strategic planning.
As a founder, you should work closely with a good startup business attorney to get the steps done properly. Self-help has its place in small businesses, but it always falls short when it comes to the complex setup issues associated with a startup. In this area, get a good lawyer to start the business and do it right.