Thursday, June 30, 2011

Lesson #56: Frequent Legal Questions of Startups

Posted By: George Deeb - 6/30/2011


& Comment

Getting good legal advice, from the very beginning of your startup, can save a lot of unnecessary hassles down the road.  For this lesson, I solicited the input of a great lawyer here in Chicago, Bart Loethen at Synergy Law Group, whose practice specializes in assisting early stage startups.  Below are some frequent questions early stage companies ask of their lawyers, and Bart's high level recommendations for each.

What business structure should I form (e.g., C-corp, S-corp, LLC)?  When building an enterprise, it is usually suggested to form it as an LLC.  An LLC brings all the legal protections of a corporation (e.g,. protects your personal assets if the company is ever sued), but avoids double taxation of the income from the business with flowthrough of the profits of the LLC directly to the shareholders.  That said, if you anticipate raising outside capital from venture capitalists, many of them will require you to form as a C-corporation for them to comply with Section 1202 of the tax code (which is set to expire in 2011, so this matter may become moot).  If a C-corporation is required by your investors, it is easy enough to transition from an LLC down the road.  If a financing is not imminent, the tax savings you will realize from the LLC is typically greater than the legal costs of switching to a C-corporation down the road.  So, more often than not, it is best to start with an LLC. 

The time to use an S-corporation is when you are launching a personal services business (e.g., law firm, ad agency, consulting firm), where you would not have multiple types of partners with different interests and where you do not intend to sell the company because the value is merely that delivered by the founder.  Also, S-corporations allow modest self employment tax savings compared to LLCs.

In what state should I form the company?  The answer to this question is largely around protecting the board of directors from any lawsuits from disgruntled investors down the road.  So, typically, venture backed businesses, or other businesses where the majority of the company is not controlled by a tight group of founders, will form their business in Delaware or Nevada, two states that provide a higher level of protection for the board of directors than in other states.  These protections will help you attract venture capital investors and high-quality outside directors for your board.  If these are not issues to you, there is no reason you cannot form your business in your home state, unless there are tax benefits of forming elsewhere.

How do I protect my intellectual capital? Do I need a patent?  Keep in mind, companies have intellectual rights whether they have a patent or not.  All a patent does is ensures no one else can come up with the same idea and claim it on their own.  The answer to whether or not it is worth the $10K average cost it takes to file a patent application varies on a company-by-company basis.  If you are a life sciences or hardcore technology business where your solution is critical to your business survival, then by all means, it makes sense to file a patent right from the start.  If you are a SaaS or services business, where protecting your process is less important to your survival, you can wait to file a patent until you have more cash flows from revenue, or after you have acheived proof of concept, when you can better afford such fees.  That said, patents are definitely selling points to talk about with investors or other partners.  So, keep that in mind, if you think it will help you close an investment. 

But, even if you have a patent as a startup, they can be very expensive to defend, often adding up to hundreds of thousands of dollars in legal fees, which most startups typically don't have lying around.  So, where you can, look for a patent lawyer who is willing to work on a contingency basis, taking their fees from any resulting awards to the company from their efforts on the back end.

How important are getting Non-Disclosure Agreements signed?  As with patents, you still have intellectual rights if you don't have an NDA in place.  So don't be too worried about sharing your idea with prospective investors.  As a rule, venture capitalists do not want to sign NDA's, and are often insulted by founders that ask them to sign an NDA, as that is not how they work.  So, proceed with VC's without an NDA, understanding there is nothing that stops them from investing in a similar business.  So, don't give away all the company secrets until you are far down the road with them.

But, for strategic partners, it is perfectly acceptable to ask for them to sign an NDA, most typically on their standard form, which your lawyer should review.  Theoretically, a strategic partner prospect is already in a similar business to start, otherwise you wouldn't be reaching out to them.  And, the benefit of an NDA is that it specially lays out your rights with governing rules of what needs to be done with the disclosed information.  More importantly, it proves they had access to the information at a certain point in time, which helps in your defense of your intellectual rights down the road, if necessary.

How should I structure my equity in the business, both for founders and outside investors?  There are too many variables based on your specific situation to specifically answer this question.  So, I will lay out a few things you need to be sensitive to around this topic. 

First of all, it is important that any work done on your business prior to formation, is legally documented as owned by the company at the time of formation.  So, collect key signatures from all founders, employees, contractors, etc. with them agreeing that all work done for the comapny was done on a "work for hire" basis and they assign all inventions to the company.  And, this document needs to be in place for any and all employees and contractors going forward, so no one can ever claim rights to the company's intellectual capital down the road.  This is relevant to equity discussions, so no previous founders or employees that are no longer working with the business, come back looking for equity value down the road after you hit it big.

If there are any co-founders in the business, their shares need to be put on a vesting schedule, earning full rights to such shares over time, in case they quit or die during the early months or years of building the business.  That way there is no confusion on what to do in those scenarios.  And, this document should clearly lay out any transfer restrictions on their equity, how the holder can liquidate their equity, and at what valuation metric, etc.  And, it should consider whether there needs to be multiple classes of stock, based on one founder investing cash or not, needing to get their invested capital returned before anyone else, or any other voting rights that need to be decided, for change in control or corporate issues.

If you are taking in outside venture capital, that opens up a whole new layer of complexity to your capital structure.  An investor will most likely be asking for preferred shares (at the top of the payout pile), with a certain level of liquidity preference (1x-3x return before common shares see any payouts).  And, they will be putting in lots of voting/board controls for themselves, and adding other restrictions on transfering or selling equity, or otherwise.  And, they will be putting in mechanisms, called rachets, that protect them from anti-dilution based on decreases in the company's valuation from "down rounds" down the road.  Way too complicated and way too many options to consider to get into any more detail for this high-level lesson.

So, as you can see, a good lawyer can help you think through all of these issues upfront, before running into any unexpected snags or ugly situations down the road.   So, if you need any futher help from here, and you most certainly will, Bart Loethen at Synergy Law Group has deep experience with startups and his hourly rates are a lot more affordable than those charged by the bigger firms.

For future posts, please follow me at:

Red Rocket is a featured contributor on entrepreneurship for many trusted business sites:

Copyright 2011- Red Rocket Partners, LLC