Listed below are ten essential legal suggestions for startup founders.
1. Arrange your legal structure early and use low-cost stock to avoid tax problems.
No small enterprise wants to take a position too heavily in legal infrastructure at an early stage. In case you are a solo founder understanding of the garage, save your dollars and give attention to development.
In case you are a team of founders, though, establishing a legal structure early is very important.
First, if members of your team are developing IP, the shortage of a structure signifies that every participant may have individual rights to the IP he develops. A key founder can guard against this by getting everyone to sign “work-for-hire” agreements assigning such rights to that founder, who in turn will assign them over to the corporation once formed. What number of founding teams do that. Almost none. Get the entity in place to capture the IP for the corporate because it is being developed.
Second, how do you get a founding team together with no structure? You may, in fact, but it surely is awkward and also you wind up with having to make guarantees that should be taken on faith about what is going to or is not going to be given to members of the team. On the flip side, many a startup has been sued by a founder who claimed that he was promised far more than was granted to him when the corporate was finally formed. As a team, don’t set yourselves up for this type of lawsuit. Set the structure early and get things in writing.
In case you wait too long to set your structure up, you run into tax traps. Founders normally work for sweat equity and sweat equity is a taxable commodity. In case you wait until your first funding event before establishing the structure, you give the IRS a measure by which to place a relatively large number on the worth of your sweat equity and also you subject the founders to useless tax risks. Avoid this by establishing early and using low-cost stock to position things for the founding team.
Finally, get a reliable startup business lawyer to assist with or no less than review your proposed setup. Do that early on to assist flush out problems before they turn out to be serious. For instance, many founders will moonlight while holding on to full-time jobs through the early startup phase. This often poses no special problems. Sometimes it does, nevertheless, and particularly if the IP being developed overlaps with IP held by an employer of the moonlighting founder. Use a lawyer to discover and address such problems early on. It’s far more costly to sort them out later.
2. Normally, go together with an organization as an alternative of an LLC.
The LLC is a powerful modern legal invention with a wild popularity that stems from its having turn out to be, for sole-member entities (including husband-wife), the trendy equivalent of the only proprietorship with a limited liability cap on it.
Whenever you move beyond sole member LLCs, nevertheless, you essentially have a partnership-style structure with a limited liability cap on it.
The partnership-style structure doesn’t lend itself well to common features of a startup. It’s a careless vehicle for restricted stock and for preferred stock. It doesn’t support the usage of incentive stock options. It can’t be used as an investment vehicle for VCs. There are special cases where an LLC is sensible for a startup but these are comparatively few in number (e.g., where special tax allocations make sense, where a profits-only interest is very important, where tax pass-through adds value). Work with a lawyer to see if special case applies. If not, go together with an organization.
3. Be cautious about Delaware.
Delaware offers few, if any benefits, for an early-stage startup. The various praises sung for Delaware by business lawyers are justified for big, public firms. For startups, Delaware offers mostly administrative inconvenience.
Some Delaware benefits from the standpoint of an insider group: (1) you may have a sole director constitute all the board of directors regardless of how large and sophisticated the company setup, giving a dominant founder a vehicle for keeping all the things close the vest (if that is deemed desirable); (2) you may dispense with cumulative voting, giving leverage to insiders who need to keep minority shareholders from having board representation; (3) you may stagger the election of directors if desired.
Delaware is also an efficient state for doing corporate filings, as anyone who has been frustrated by the delays and screw-ups of certain other state agencies can attest.
On the down side — and that is major — Delaware permits preferred shareholders who control nearly all of the corporate’s voting stock to sell or merge the corporate without requiring the consent of the common stock holders. This could easily result in downstream founder “wipe outs” via liquidation preferences held by such controlling shareholders.
Also on the down side, early-stage startups incur administrative hassles and additional costs with a Delaware setup. They still should pay taxes on income derived from their home states. They should qualify their Delaware corporation as a “foreign corporation” of their home states and pay the additional franchise fees related to that process. They get franchise tax bills within the tens of hundreds of dollars and should apply for relief under Delaware’s alternative valuation method. None of these things constitutes a crushing problem. Each one is an administrative hassle.
My advice from years of experience working with founders: keep it easy and skip Delaware unless there may be some compelling reason to decide on it; if there may be a very good reason, go together with Delaware but don’t idiot yourself into believing that you could have gotten yourself special prize in your early-stage startup.
4. Use restricted stock for founders typically.
If a founder gets stock without strings on it, after which walks away from the corporate, that founder will get a windfall equity grant. There are special exceptions, however the rule for many founders needs to be to grant them restricted stock, i.e., stock that may be repurchased by the corporate at cost within the event the founder leaves the corporate. Restricted stock lies at the center of the concept of sweat equity for founders. Use it to ensure that founders earn their keep.
5. Make timely 83(b) elections.
When restricted stock grants are made, they need to almost all the time be accompanied by 83(b) elections to forestall potentially horrific tax problems from arising downstream for the founders. This special tax election applies to cases where stock is owned but may be forfeited. It should be made inside 30 days of the date of grant, signed by the stock recipient and spouse, and filed with the recipient’s tax return for that 12 months.
6. Get technology assignments from everyone who helped develop IP.
When the startup is formed, stock grants mustn’t be made only for money contributions from founders but additionally for technology assignments, as applicable to any founder who worked on IP-related matters prior to formation. Don’t leave these hangning loose or allow stock to be issued to founders without capturing all IP rights for the corporate.
Founders sometimes think they will keep IP in their very own hands and license it to the startup. This doesn’t work. No less than the corporate is not going to normally be fundable in such cases. Exceptions to this are rare.
The IP roundup should include not only founders but all consultants who worked on IP-related matters prior to company formation. Modern startups will sometimes use development firms in places like India to assist speed product development prior to company formation. If such firms were paid for this work, and in the event that they did it under work-for-hire contracts, then whoever had the contract with them can assign to the startup the rights already captured under the work-for-hire contracts. If no work-for-hire arrangements were in place, a stock, stock option, or warrant grant needs to be made, or other legal consideration paid, to the skin company in exchange for the IP rights it holds.
The identical is true for each contractor or friend who helped with development locally. Small option grants will be certain that IP rights are rounded up from all relevant parties. These grants needs to be vested in whole or partly to be certain that proper consideration exists for the IP project made by the consultants.
7. Protect the IP going forward.
When the startup is formed, all employees and contractors who proceed to work for it should sign confidentiality and invention project agreements or work-for-hire contracts as appropriate to be certain that all IP stays with the corporate.
Such individuals also needs to be paid valid consideration for his or her efforts. If that is in the shape of equity compensation, it needs to be accompanied by some form of money compensation as well to avoid tax problems arising from the IRS placing a high value on the stock through the use of the reasonable value of services as a measure of its value. If money is an issue, salaries could also be deferred as appropriate until first funding.
8. Consider provisional patent filings.
Many startups have IP whose value will largely be lost or compromised once it’s disclosed to the others. In such cases, see a very good patent lawyer to find out a patent strategy for shielding such IP. If appropriate, file provisional patents. Do that before making key disclosures to investors, etc.
If early disclosures should be made, do that incrementally and only under the terms of non-disclosure agreements. In cases where investors refuse to sign an nda (e.g., with VC firms), don’t reveal your core confidential items until you could have the provisional patents on file.
9. Arrange equity incentives.
With any true startup, equity incentives are the fuel that keeps a team going. At formation, adopt an equity incentive plan. These plans will give the board of directors a variety of incentives, unsually including restricted stock, incentive stock options (ISOs), and non-qualified options (NQOs).
Restricted stock is generally used for founders and really key people. ISOs are used for workers only. NQOs may be used with any worker, consultant, board member, advisory director, or other key person. Each of those tools has differing tax treatment. Use a very good skilled to advise you on this.
After all, with all types of stock and options, federal and state securities laws should be satisfied. Use a very good lawyer to do that.
10. Fund the corporate incrementally.
Resourceful startups will use funding strategies by which they do not necessarily go for big VC funding right out the gate. After all, a number of the absolute best startups have needed major VC funding at inception and have achieved tremendous success. Most, nevertheless, will get into trouble in the event that they need massive capital infusions right up front and thereby find themselves with few options if such funding just isn’t available or if it is obtainable only on oppressive terms.
The perfect results for founders come once they have built significant value within the startup before needing to hunt major funding. The dilutive hit is far less they usually often get a lot better general terms for his or her funding.
The following pointers suggest essential legal elements that founders should factor into their broader strategic planning.
As a founder, it is best to work closely with a very good startup business lawyer to implement the steps accurately. Self-help has its place in small firms, but it surely almost invariably falls short on the subject of the complex setup issues related to a startup. On this area, get a very good startup business lawyer and do it right.