| Here are ten essential legal tips for startup founders. | | | | windfall equity grant. There are special exceptions, but |
| 1. Set up your legal structure early and use cheap | | | | the rule for most founders should be to grant them |
| stock to avoid tax problems. | | | | restricted stock, i.e., stock that can be repurchased by |
| No small venture wants to invest too heavily in legal | | | | the company at cost in the event the founder leaves |
| infrastructure at an early stage. If you are a solo | | | | the company. Restricted stock lies at the heart of the |
| founder working out of the garage, save your dollars | | | | concept of sweat equity for founders. Use it to make |
| and focus on development. | | | | sure founders earn their keep. |
| If you are a team of founders, though, setting up a | | | | 5. Make timely 83(b) elections. |
| legal structure early is important. | | | | When restricted stock grants are made, they should |
| First, if members of your team are developing IP, the | | | | almost always be accompanied by 83(b) elections to |
| lack of a structure means that every participant will | | | | prevent potentially horrific tax problems from arising |
| have individual rights to the IP he develops. A key | | | | downstream for the founders. This special tax election |
| founder can guard against this by getting everyone to | | | | applies to cases where stock is owned but can be |
| sign "work-for-hire" agreements assigning such rights | | | | forfeited. It must be made within 30 days of the date |
| to that founder, who in turn will assign them over to the | | | | of grant, signed by the stock recipient and spouse, and |
| corporation once formed. How many founding teams | | | | filed with the recipient's tax return for that year. |
| do this. Almost none. Get the entity in place to capture | | | | 6. Get technology assignments from everyone who |
| the IP for the company as it is being developed. | | | | helped develop IP. |
| Second, how do you get a founding team together | | | | When the startup is formed, stock grants should not |
| without a structure? You can, of course, but it is | | | | be made just for cash contributions from founders but |
| awkward and you wind up with having to make | | | | also for technology assignments, as applicable to any |
| promises that must be taken on faith about what will | | | | founder who worked on IP-related matters prior to |
| or will not be given to members of the team. On the | | | | formation. Don't leave these hangning loose or allow |
| flip side, many a startup has been sued by a founder | | | | stock to be issued to founders without capturing all IP |
| who claimed that he was promised much more than | | | | rights for the company. |
| was granted to him when the company was finally | | | | Founders sometimes think they can keep IP in their |
| formed. As a team, don't set yourselves up for this | | | | own hands and license it to the startup. This does not |
| kind of lawsuit. Set the structure early and get things in | | | | work. At least the company will not normally be |
| writing. | | | | fundable in such cases. Exceptions to this are rare. |
| If you wait too long to set your structure up, you run | | | | The IP roundup should include not only founders but all |
| into tax traps. Founders normally work for sweat | | | | consultants who worked on IP-related matters prior to |
| equity and sweat equity is a taxable commodity. If you | | | | company formation. Modern startups will sometimes |
| wait until your first funding event before setting up the | | | | use development companies in places like India to help |
| structure, you give the IRS a measure by which to put | | | | speed product development prior to company |
| a comparatively large number on the value of your | | | | formation. If such companies were paid for this work, |
| sweat equity and you subject the founders to | | | | and if they did it under work-for-hire contracts, then |
| needless tax risks. Avoid this by setting up early and | | | | whoever had the contract with them can assign to the |
| using cheap stock to position things for the founding | | | | startup the rights already captured under the |
| team. | | | | work-for-hire contracts. If no work-for-hire |
| Finally, get a competent startup business lawyer to | | | | arrangements were in place, a stock, stock option, or |
| help with or at least review your proposed setup. Do | | | | warrant grant should be made, or other legal |
| this early on to help flush out problems before they | | | | consideration paid, to the outside company in |
| become serious. For example, many founders will | | | | exchange for the IP rights it holds. |
| moonlight while holding on to full-time jobs through the | | | | The same is true for every contractor or friend who |
| early startup phase. This often poses no special | | | | helped with development locally. Small option grants will |
| problems. Sometimes it does, however, and especially | | | | ensure that IP rights are rounded up from all relevant |
| if the IP being developed overlaps with IP held by an | | | | parties. These grants should be vested in whole or in |
| employer of the moonlighting founder. Use a lawyer to | | | | part to ensure that proper consideration exists for the |
| identify and address such problems early on. It is much | | | | IP assignment made by the consultants. |
| more costly to sort them out later. | | | | 7. Protect the IP going forward. |
| 2. Normally, go with a corporation instead of an LLC. | | | | When the startup is formed, all employees and |
| The LLC is a magnificent modern legal invention with a | | | | contractors who continue to work for it should sign |
| wild popularity that stems from its having become, for | | | | confidentiality and invention assignment agreements or |
| sole-member entities (including husband-wife), the | | | | work-for-hire contracts as appropriate to ensure that |
| modern equivalent of the sole proprietorship with a | | | | all IP remains with the company. |
| limited liability cap on it. | | | | Such persons should also be paid valid consideration |
| When you move beyond sole member LLCs, | | | | for their efforts. If this is in the form of equity |
| however, you essentially have a partnership-style | | | | compensation, it should be accompanied by some |
| structure with a limited liability cap on it. | | | | form of cash compensation as well to avoid tax |
| The partnership-style structure does not lend itself well | | | | problems arising from the IRS placing a high value on |
| to common features of a startup. It is a clumsy vehicle | | | | the stock by using the reasonable value of services as |
| for restricted stock and for preferred stock. It does | | | | a measure of its value. If cash is a problem, salaries |
| not support the use of incentive stock options. It | | | | may be deferred as appropriate until first funding. |
| cannot be used as an investment vehicle for VCs. | | | | 8. Consider provisional patent filings. |
| There are special cases where an LLC makes sense | | | | Many startups have IP whose value will largely be lost |
| for a startup but these are comparatively few in | | | | or compromised once it is disclosed to the others. In |
| number (e.g., where special tax allocations make | | | | such cases, see a good patent lawyer to determine a |
| sense, where a profits-only interest is important, where | | | | patent strategy for protecting such IP. If appropriate, |
| tax pass-through adds value). Work with a lawyer to | | | | file provisional patents. Do this before making key |
| see if special case applies. If not, go with a corporation. | | | | disclosures to investors, etc. |
| 3. Be cautious about Delaware. | | | | If early disclosures must be made, do this incrementally |
| Delaware offers few, if any advantages, for an | | | | and only under the terms of non-disclosure |
| early-stage startup. The many praises sung for | | | | agreements. In cases where investors refuse to sign |
| Delaware by business lawyers are justified for large, | | | | an nda (e.g., with VC firms), don't reveal your core |
| public companies. For startups, Delaware offers mostly | | | | confidential items until you have the provisional patents |
| administrative inconvenience. | | | | on file. |
| Some Delaware advantages from the standpoint of | | | | 9. Set up equity incentives. |
| an insider group: (1) you can have a sole director | | | | With any true startup, equity incentives are the fuel |
| constitute the entire board of directors no matter how | | | | that keeps a team going. At formation, adopt an equity |
| large and complex the corporate setup, giving a | | | | incentive plan. These plans will give the board of |
| dominant founder a vehicle for keeping everything | | | | directors a range of incentives, unsually including |
| close the vest (if this is deemed desirable); (2) you can | | | | restricted stock, incentive stock options (ISOs), and |
| dispense with cumulative voting, giving leverage to | | | | non-qualified options (NQOs). |
| insiders who want to keep minority shareholders from | | | | Restricted stock is usually used for founders and very |
| having board representation; (3) you can stagger the | | | | key people. ISOs are used for employees only. NQOs |
| election of directors if desired. | | | | can be used with any employee, consultant, board |
| Delaware also is an efficient state for doing corporate | | | | member, advisory director, or other key person. Each |
| filings, as anyone who has been frustrated by the | | | | of these tools has differing tax treatment. Use a good |
| delays and screw-ups of certain other state agencies | | | | professional to advise you on this. |
| can attest. | | | | Of course, with all forms of stock and options, federal |
| On the down side -- and this is major -- Delaware | | | | and state securities laws must be satisfied. Use a |
| permits preferred shareholders who control the | | | | good lawyer to do this. |
| majority of the company's voting stock to sell or | | | | 10. Fund the company incrementally. |
| merge the company without requiring the consent of | | | | Resourceful startups will use funding strategies by |
| the common stock holders. This can easily lead to | | | | which they don't necessarily go for large VC funding |
| downstream founder "wipe outs" via liquidation | | | | right out the gate. Of course, some of the very best |
| preferences held by such controlling shareholders. | | | | startups have needed major VC funding at inception |
| Also on the down side, early-stage startups incur | | | | and have achieved tremendous success. Most, |
| administrative hassles and extra costs with a | | | | however, will get into trouble if they need massive |
| Delaware setup. They still have to pay taxes on | | | | capital infusions right up front and thereby find |
| income derived from their home states. They have to | | | | themselves with few options if such funding is not |
| qualify their Delaware corporation as a "foreign | | | | available or if it is available only on oppressive terms. |
| corporation" in their home states and pay the extra | | | | The best results for founders come when they have |
| franchise fees associated with that process. They get | | | | built significant value in the startup before needing to |
| franchise tax bills in the tens of thousands of dollars | | | | seek major funding. The dilutive hit is much less and |
| and have to apply for relief under Delaware's | | | | they often get much better general terms for their |
| alternative valuation method. None of these items | | | | funding. |
| constitutes a crushing problem. Every one is an | | | | Conclusion |
| adminstrative hassle. | | | | These tips suggest important legal elements that |
| My advice from years of experience working with | | | | founders should factor into their broader strategic |
| founders: keep it simple and skip Delaware unless | | | | planning. |
| there is some compelling reason to choose it; if there is | | | | As a founder, you should work closely with a good |
| a good reason, go with Delaware but don't fool | | | | startup business lawyer to implement the steps |
| yourself into believing that you have gotten yourself | | | | correctly. Self-help has its place in small companies, but |
| special prize for your early-stage startup. | | | | it almost invariably falls short when it comes to the |
| 4. Use restricted stock for founders in most cases. | | | | complex setup issues associated with a startup. In this |
| If a founder gets stock without strings on it, and then | | | | area, get a good startup business lawyer and do it |
| walks away from the company, that founder will get a | | | | right. |