Forming Your Business

Forming Your Business : A Practical Approach By : Ilana Lubin / Sullivan & Cromwell

April 2015

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Forming Your Business: A Practical Approach

March 31, 2015

Why incorporate?

• Why incorporate? – Limit your personal exposure! – Isolate assets – Enhance your credibility

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Choosing your entity

• Choosing your entity & jurisdiction of formation – Rule of Thumb !Delaware Corporation – Discuss other alternatives with your lawyer

and/or accountant, considering: • Fees (i.e., to incorporate & administer) • Your business (i.e., are you a one man shop?) • Your goals & timeline

– Conversion is an option

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Example of costsCorporation:

Required Organizational Documents

Delaware New York

Certificate of Incorporation $685 (fee will increase or decrease based on number and par value of authorized shares; fee includes a registered agent fee of $342.00)

$732 (includes a registered agent fee of $342)

By-Laws N/A N/A

Stockholders Agreement N/A N/AStatement of the Incorporator N/A N/A

Initial Resolutions of the Board of Directors

N/A N/A

Minute Book $84 $84LLC:

Required Organizational Documents

Delaware New YorkCertificate of Formation/Articles of Organization $690 (includes a registered agent

fee of $342) $807 (includes a registered agent fee of $342)

Publication N/A $2199 (as determined based upon the two designated newspapers chosen by the county clerk)

Operating Agreement N/A N/A

Initial Resolutions N/A N/A

Minute Book $84 $84

Types of entities & jurisdictional considerations

Advantages and Disadvantages

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LLC Corporation

Pros • Flexibility • Sophisticated tax structuring • Flow through taxation

• Easier to grant equity incentives (options & RSUs) • Formalities are straight forward

Cons • Complicated tax structuring • Complications regarding the grant of equity incentives

• Increased corporate formalities • 2 levels of taxation

Corporate Entity Types

• Sole proprietorship • General partnership • Limited partnership • Corporation • Limited Liability Company • Limited Liability Partnership

• Disregarded • Partnership • C corporation • S corporation

Tax Entity Types

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• Choice of entity for corporate purposes does not necessarily dictate how it will be treated for tax purposes. This can change how you complete the SS-4 to obtain an EIN.

• A sole proprietorship and any entity other than an Inc. will generally be treated as a disregarded entity for tax purposes by default or can elect to be treated as a disregarded entity, as long as it has only one member. This is also the default classification for single-member LLCs.

• Disregarded entity is completely ignored for federal and state income tax purposes. (It is usually “regarded” for sales and property tax purposes.)

• Owner is subject to income tax at his own rates on the income of the disregarded entity.

Disregarded Entity

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Feature S Corporation Partnership/LLCFormation File with state File with stateNumber of Owners Restricted to 100

shareholdersGenerally, unlimited number of members (owners)Corporate Owners Allowed No Yes

Foreign Owners Allowed No YesDifferent Classes of Shares Permitted?

Yes, as long as all of the classes have identical economic rights (rights to dividends and liquidating proceeds). Shares may have

Yes – Shares can have both different economic and voting rights.

Liability Protection Yes YesCorporation Formalities (assuming state law corporation)

Many mandated corporate formalities, including, but not limited to: - Annual meetings - Election of Board of

Directors - Election of officers

Few mandated corporate formalities. However, typically members choose to create such formalities through an Operating AgreementManagement (assuming state

law corporation)Board of directors As decided by

membersProfit Sharing Directly proportional to

ownership percentage. All shares must convey equal economic rights.

As decided by members

Annual Accounting Costs May be lower May be higherQuarterly Estimated Tax Payments Made by Members

Yes, with respect to residual profits (corporation withholds on salary because shareholder can be employee).

Yes, with respect to both salary and residual profits (partner cannot be employee)Social Security and Medicare

TaxPaid only on salary (though new 3.8% tax that started in January 2013 applies to passive earnings).

Generally paid on all earnings from LLC (salary and profits)

Side-by-Side Comparison of S Corp vs Partnership/LLC

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• Choose DE • Well developed body of corporate law • Sophisticated courts • Every corporate lawyer, and more importantly,

VC investor is familiar with DE documents and law– this is what they want to see. You are making getting funding easier both practically speaking but also by conveying credibility and legitimacy. • Another reason, see: NY Business Corporation

Law §630 – Liability of Shareholders for Wages Due to Laborers, Servants or Employees

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“The ten largest shareholders….shall jointly and severally be personally liable for all debts, wages or salaries due and owing to any of its laborers, servants or employees other than contractors, for services performed by them for such corporation…” - N.Y. BSC. LAW Section 630 - This does not apply to a publicly traded

company

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• Remember to apply for authority to do business in the states you are doing business – If you are a DE LLC, this will result in publication fees in

NY • Conduct name reservations and trademark

clearances if the company name will be consumer facing

• A great resource: Delaware Secretary of State website

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“Corporation In-A-Box” – The basic documents that get you up & running brought to you by

C&M’s Corporate Formation Questionnaire can help you organize and focus on initial decisions that need to be made:

– Set a number of directors and decide who will be your directors.

– Determine how you will divide equity interests? And what is the consideration for each? (i.e., cash, intellectual property, sweat)

– Consider a Pre-Nup. • Vesting/accelerations schedules

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“Corporation In-A-Box” – The basic documents that get you up & running

• Certificate of Incorporation – Authorized Number of Shares. (a lower number with a lower par

value (i.e., 0001 will make your annual franchise taxes cheaper (the minimum tax is $175-350; you can always authorize more; on the other hand, think optics when issuing options (a grant of 10 can have the same value as 100 but 100 sounds better)

• Action of Incorporator (signs the original certificate, adopts bylaws and elects initial directors)

• Bylaws (rules of how the company conducts its affairs, which must be consistent with the DE law and the charter; they cover meetings, voting, officers, directors, indemnification, fiscal year, etc.)

• Consent of the Board (adopting Action of Incorporator, COI, Bylaws; electing officers, adopting relevant agreements)

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Corporation in a box – The basic documents that get you up & running

• Founders Common Stock Purchase Agreement (this can also be a subscription agreement) – Typical purchase price at founding is 10 x par value (.0001) = $.001, but if

there is substantial value in the Company at formation then the purchase price could be something different (i.e., book value of assets), and this should be discussed with tax counsel

– Can use vesting restrictions here • VCs may want to see this for assurance people will stick around • Helpful if you have multiple founders because you have pre-negotiated how to deal

with someone leaving or becoming disinterested. A “founder divorce” is common when you have 3 or more founders.

– Transfer limitations (Securities Law; Right of First Refusal) – Lock Up – Bill of Sale/Assignment and Assumption for non-cash consideration such

as intellectual property or other assets

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• D&O Indemnification Agreement – Your VC board representatives will certainly

want this and namely primacy of indemnification

• Non-Disclosure Agreement – This allows you to start commercial

discussions with companies by protecting your confidential information

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• Employment Agreements • Consultant Agreements • Confidential Information and Invention

Assignment Agreement –Work for hire doctrine – Non-Solicits & Non-Competes – Mischaracterization Issues

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Other Practical Considerations – Protecting Your Assets

Intellectual Property Employees

Real Estate Key Contracts

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Intellectual Property - Types

• Patents (Provisional, Design & Utility) Inventions

• Copyrights Expression

(GUI, Software, Books, Apps, Website Content)

• Trademarks Source Identifier

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Intellectual Property - Patents

Disclosure is a bar to patent protection. Remember to rely on your NDA.

Provisional Patent = A Stake in the Sand • Be the first to the patent office & preserve rights

globally • Make commercialization easier • Obtain the benefit of using “patent pending”

– You will have one year to submit full patent application with claims and proper drawings

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Intellectual Property – Patents

Utility Patents Design Patents Provisional

Process, machine, manufacture, or composition matter or improvement thereof

Ornamental Designs Your stake in the sand

20 years from first filing date

14 years from date of grant

1 year from filing date

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Intellectual Property – Copyrights & Trademarks

Copyrights Trademarks

Protected on creation Rights inure upon use

Registration is cheap

A U.S. citizen needs a copyright to be registered in

Registration is based on geography

© 2012 Jane DoeUnregistered ™ Registered ®

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Trade Secrets

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Information

Reasonable measures taken to protect the information

Derives independent economic value from not being publicly known

Other Practical Considerations Privacy Policies • Be clearly posted, with appropriate links • Must accurately inform users about a website operator’s practices

regarding its collection and use of information, including personal information (i.e., social media applications, direct marketing). This is specifically tailored to YOU.

• Practices must comply with privacy and data security laws (i.e., COPPA, HIPPA)

• Should be consistent with the terms of use

Terms of Use • Can minimize liability to site users, protect intellectual property by

prohibiting unauthorized reproduction, and prohibit certain behaviors (i.e., introducing viruses)

• Clickwrap

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Other Practical Considerations

• Get the insurance policies you will need for your business. One lawsuit could make or break you. – Commercial General Liability – Cyber Security / Data breaches – Industry specific, i.e., Food Contamination

Policy

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Funding – Types of Investors

– Friend & Family – Angels (i.e., Jeff Bezos, Paul Graham) – Venture Capital Funds – Strategic Inventors

(i.e., Peacock Equity Fund (GE/NBC Universal); Simon Venture Group (Simon))

– Leasing Companies – Banks

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Funding – Types of Investments• Common Stock • Preferred Stock • Convertible Promissory Notes • Warrants • Subordinated Debt (with or without an

equity “kicker” – see above)

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Funding

• How much to raise? – Rule of Thumb: Raise for 9-18 months – Raise enough to get the company off of the

ground • Develop a beta version or proto-type • Develop your website • Generate initial revenues • Sign a key contract • Hire key management

•You will probably need to raise capital more than once

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Funding – Securities LawA company should register the offer and sale of securities with the SEC unless there is a corresponding exemption (Securities Act of 1933)

You need an exemption: – 4(2) “private offering” (no filing required)

• Used for a limited number of people (think: 10) • Insider access to information is key • Sophistication (except for founders) • Ability to absorb loss • Subject to transfer or resale restrictions

– Regulation D (Form D filing required)

Blue Sky Laws28

Funding

Think about your end-game:

M&A, IPO, Lifestyle

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Speaker

Ilana Lubin New York [email protected] Phone: +1 212.895.4224

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