NYTECH Presents "Legal Essentials for Startups: Part 1 of 3 - Organizing the Entity"

Legal Essentials for Startups:

Part 1 of 3 – Organizing the Entity

Frode Jensen

October 25, 2012

1375 Broadway, New York, NY

https://www.nytech.org/

Disclaimer

The materials and information contained in this presentation are presented for informational

purposes only and do not constitute advertising, solicitation or legal advice. Although care

has been taken to ensure that the materials are correct, complete and up-to-date, the

presenters and their firms assume no responsibility therefor. Accordingly, you should not

act or rely on any information in this program without seeking the advice of an attorney

licensed to practice law in your jurisdiction.

The materials contained in this presentation do not create and are not intended to create an

attorney-client relationship between you and any of the presenters, Holland & Knight LLP,

Paul Ellis Law Group LLC or Frankfurt Kurnit Klein & Selz.

2


Agenda

3

Holland & Knight

Preliminary considerations

Choosing the business entity

Where to incorporate

Structuring considerations

Other considerations

Takeaways


Holland & Knight: Who We Are

• Our profile

– Holland & Knight is a global law firm with approximately 1,000 lawyers in 21 offices in

the U.S. and abroad

– We have been named by BTI as one of the top 10 firms in the U.S. for client service,

reputation and innovation (June 2012)

• We are value and service-oriented

– We work as a team using a “one firm” structure for matters ranging from simple to

complex

– We draw upon our broad legal experience and industry knowledge to provide

efficient, high value service

• We are innovative

– We offer a broad range of perspectives that a diverse team brings, thus encouraging

innovative thinking and unique solutions

• We are diverse

– Our lawyers reflect the national and international marketplace as well as communities

in which we practice

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Holland & Knight Offices

Jacksonville

Chicago

Boston

New York

Atlanta

Tallahassee

Orlando

West Palm Beach

Fort Lauderdale

Miami

Northern Virginia Washington, D.C.

Tampa

Los Angeles

San Francisco

Portland

Lakeland International Offices

Abu Dhabi, United Arab Emirates

Beijing, China

Bogotá, Colombia

Mexico City, Mexico

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Today’s Panel

6

Practice Education Bar Admission

7

Frode Jensen

Frode Jensen

Partner

Holland & Knight, LLP

212.513.3462

[email protected]

www.hklaw.com

Frode has represented numerous entrepreneurs, managers and institutional

and individual investors in startups, early stage companies and growth

companies in a wide range of industries, including biotechnology,

pharmaceuticals, communications, data collection, retailing and distribution,

as well as numerous "old economy" industries.

• Venture Capital &

Private Equity

• Corporate

Governance

• Mergers & Acquisition

• Financial Services

• Williams College, B.A.

• Columbia University

Law School, J.D.

• New York

• Connecticut



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Glen K. Westerback

Glen K. Westerback

Associate

Frankfurt Kurnit Klein & Selz

212.826.5563

[email protected]

www.fkks.com

Glen counsels clients on software, e-commerce and Internet issues, including matters

related to classic Web-enabled commerce, privacy and data security, blogging and social

networking, cloud computing, online advertising, and the development and licensing of

websites, mobile apps, and other software and leading edge innovations.

Glen also helps media, technology and other innovative companies organize and

reorganize, structure entrepreneurial ventures, and access financing. He has advised

clients on mergers and acquisitions, marketing and distribution agreements, licensing of

intellectual property, and services agreements, employment, and other corporate

arrangements.

• Corporate and

Finance

• Technology,

eCommerce and

Privacy

• The College of William

& Mary, B.A.

• Cornell Law School,

J.D.

• New York



9

Paul Ellis

Paul Ellis

Managing Member

Paul Ellis Law Group LLC

212.949.5900

[email protected]

www.pelglaw.com

Paul is a founding board member of the New York Technology Council (NYTECH) and

leads NYTECH’s bi-monthly series of legal events. He has represented companies ranging

from startups to multinationals, as well as funds and individual and institutional investors.

Paul counsels on issues including formation, early-stage financing, joint venture and

strategic partnering relationships, employment, equity plans, mergers and acquisitions,

and, together with his colleagues, protection and licensing of intellectual property. Beyond

the software/internet/IT industries, he has practiced in industries including

telecommunications, healthcare, manufacturing, banking, real estate, consumer products

and entertainment.

• General Corporate/

Contracts

• Financing/Venture

Capital

• Intellectual Property

• Harvard University,

B.A.

• Georgetown University

Law Center, J.D.

• New York


Agenda

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Holland & Knight






Takeaways


Preliminary considerations: Show stoppers

• If an idea seems to have a commercial application – if it entails a product or service

which could be traded for money – the possessor of the idea should consider:

– Does the idea belong to someone else?

• Am I subject to an employment agreement which gives rights in the idea to my

employer?

• Is the idea clearly subject to someone else’s copyright, trademark or patent?

– Am I restricted from competing?

• Am I subject to a restrictive employment agreement or a non-competition

agreement?

– Am I restricted from asking colleagues from a prior employer to partner up with me?

• Am I subject to a non-solicitation agreement?

• If the answers are no, let’s go!

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Agenda

12

Holland & Knight






Takeaways


South Park Plan: How Not to Start a Company

13


Lifespan of a business

Lifespan of

a business

“Idea”

Implementation of

strategy/revenue stage

Execution of idea/

build prototype

Organization

of startup

company

Exit

14

Optimize potential

and operate


Starting up

15


Trigger event for organizing an entity

• It is often difficult to define a rule of thumb for the triggering event that should lead an

entrepreneur to move from “brainstorming” to deciding to organize a business as a more

formal entity

• The following circumstances can act as a trigger:

– The founder begins to spend more than just a trivial amount of money on the startup

– The possibility of commercialization of the “idea” becomes reasonable

– There are co-founders or the founder is contemplating taking on partners or asking

for other people’s money

– The founder is concerned about personal liability protection

16


Organizing an entity “too late”

• Many founders wait to formally “incorporate” (or organize a non-corporate entity) until

they are convinced that their “idea” will be viable/profitable

– Waiting may be a mistake, as many aspects of business development prior to

establishing “viability” will benefit from creating an entity

– In a competitive industry, first mover advantages may be lost by waiting too long

– Founders may be unaware of the risks of waiting

• Liabilities arising before incorporation generally cannot be erased by

subsequent incorporation

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Possible business structures

• When starting a business, one of the first questions that needs to be

addressed is the question of which type of entity

• Numerous alternative business structures exist, but the most relevant forms to

consider are:

– Sole proprietorship

– Partnership

– Limited Liability Company (LLC)

– Corporation

• The optimal business structure depends on the specific circumstances of the

founder(s), the business plan and the entity itself

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Reasons for organizing an entity

• The reasons to organize an entity include:

– Limit liability and protect personal assets

– Accounting clarity and separation

– Tax minimization and flexibility

– Vehicle for external funding

– Credibility with third parties

– Multiple founder(s) or partner(s)

– Enhance protection of intellectual property rights

– Accommodate employees (and related compensation issues)

• A more indirect advantage of entity creation is “the benefit of leading a tidy life”

– the founder is forced to focus on structure, governance and documentation before

problems arise

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Criteria in selecting optimal business structure

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• Double taxation (taxation of both corporation and stockholder) versus

pass-through treatment where the corporate entity is not taxed

• Taxation on exit

• Limitation of liability (up to value of equity contribution) versus

unlimited personal liability

• Costs of entity organization and continued administration of entity

• Accommodate funding and governance concerns

• Attract and retain key employees

• Equity incentive compensation

• Certain tax benefits from retaining earnings to fund business

Taxation

Retaining

earnings

Retention of

employees

Funding and

governance

considerations

Administrative

costs

Liability

2

3

4

5

1

6


Snapshot: The role of accountants

• As soon as expenditures are (or are expected to be) meaningful, an accountant with

experience and interest in dealing with startups should be retained

• More and more accountants are willing to accept modest, fixed or capped fees in the

early stages of startups

• However, some accountants will also advise on legal issues, including questions of

organizational structure and documentation

– The roles of the accountant and the lawyer are separate and should be

respected

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Sole proprietorship

• An individual who owns a business which is not incorporated or organized as a separate

legal entity is referred to as a “sole proprietor” and his/her business as a “sole

proprietorship”

• If you do nothing (to organize), you will be in effect a “sole proprietorship”

• Only possible to use sole proprietorship when there is one owner (or, in some cases, a

husband and wife)

– Inappropriate form for a business with multiple founders, investors or partners

22


Sole proprietorship

• The owner manages the business and is personally liable for all business debt and other

obligations

• General legal rules on contract, tort, etc. govern the sole proprietorship and no specific

regulations apply

• Cheap, easy and fast to “set up” and to maintain

• No requirement to register an entity with state regulatory authorities

• May require state and local regulatory compliance and/or business license

• No governance agreements such as by-laws or stockholder agreements

• The sole proprietorship and the owner are treated as one entity for tax purposes

– the sole proprietorship cannot retain profits and avoid paying individual taxes

• The business cannot be sold as an entity (as in the case of a corporation or an LLC)

– the business can be sold in an asset sale

23


Partnership

• A partnership is a business organization in which

two or more individuals (partners) manage and

operate the business

• If two individuals start a business together and do

not form a limited liability entity, chances are they

will be found to be general partners doing business

as a General Partnership

• Two types of partnerships exist:

– A General Partnership

• the partners have unlimited liability

– A Limited Partnership

• the general partner(s) have unlimited liability

• the limited partner(s) have limited liability

• Because general partners have unlimited liability, the general partnership consisting of

individuals is rarely used today

• A partnership is a pass-through tax entity

– Profit and losses are attributed to partners irrespective of whether distributions are

made to partners

24


Limited Partnership

• A Limited Partnership is a partnership with limited liability characteristics and pass-

through tax treatment

• Each state has a law authorizing and regulating Limited Partnerships

• General Partner(s) are personally liable for business debts and liabilities

– There must be at least one General Partner (with unlimited liability) in a Limited

Partnership

• Limited Partners do not generally have personal liability

– Limited Partner(s) who control the business are personally liable

25


Limited Partnership Agreement

• The limited partnership agreement deals with day-to-day management of the

partnership, profit sharing and termination

– Profits can be divided among the partners as desired by the partners

– The General Partner(s) manage the business

– Transferability of interests in a limited partnership may be restricted

– Limited Partnerships are often assumed to be cheaper to maintain (since there are

no formal requirements for minutes of meetings or for boards of directors or officers)

• This can be a false assumption

26


Limited Liability Company (LLC)

• Upside: so much flexibility

• Downside: so much flexibility

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• An LLC is an “entity” which is not a corporation and which provides the benefits of

limited liability and pass-through tax treatment

– Limited liability depends on adherence to so-called formalities

– Pass-through tax treatment can be “elected” away

• All 50 states have passed legislation authorizing LLCs

– These laws differ slightly, e.g. regarding which businesses can be conducted by an

LLC and in the rules governing operation and maintenance of the entity

• LLCs can be seen in some respects as more flexible than corporations

– Especially in respect of management and capital structure

• LLCs are generally disfavored by venture capital and offshore investors

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• LLCs are formed by submitting articles of organization to the appropriate state

authorities

• LLCs have limited liability; the owners of an LLC (“members”) have no personal liability

(beyond value of membership/equity contribution)

– Exception: piercing the “limited liability” veil

• business affairs of LLC and members are entangled

• the LLC does not comply with the required legal formalities, e.g. failure to keep

proper records

• the LLC is undercapitalized

– Members of LLC startups are often required to guarantee loans made to the LLC

• Members enter into an operating agreement governing the management of the LLC,

distribution of profits, etc.

• A benefit of the LLC structure is significant flexibility

– An LLC can be structured to mimic a corporation or a partnership

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• The LLC is a pass-through tax entity (but it can elect to be taxed as a corporation)

• Profits can be divided among the members irrespective of ownership percentages

• The members can manage the LLC themselves or appoint separate managers

• Managers are liable to the LLC and members in connection with the performance of

their duties

– indemnifications can be provided in operating agreement

• Transferability of membership interests is governed by the operating agreement and

securities laws and regulations

• Incentivized compensation schemes may be more difficult to implement (than for

corporations)

– it is possible to offer employees membership interests but membership equity

compensation may be awkward and unattractive

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Snapshot: New York City UBT

• New York Unincorporated Business Tax (UBT) applicable to all partnerships and LLCs in

New York City (wherever organized)

– UBT is charged to every individual or unincorporated entity carrying on trade,

business or profession in New York City

– UBT is 4% for taxable income allocated to New York City

– LLCs that are not treated as corporations for tax purposes are required to pay UBT

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Snapshot: New York LLC Publication Requirement

• New York requires all domestic and foreign LLCs to publish a notice regarding the

organization or application of authority, as the case may be

– Deadline: within 120 days after effectiveness of the initial articles of organization or

the filing to do business in New York, as appropriate

– The notice shall contain certain specified information about the LLC

– The notice shall be published once in each week for six successive weeks, in two

newspapers of the county in which the office of the LLC is located

• One newspaper shall be printed daily and the other newspaper shall be printed

weekly

– If the publication is not made, the authority of such LLC to carry on, conduct or

transact any business in New York State shall be suspended

– Costs to publish the notice varies depending on the county

• Costs are estimated at between $ 200-300 (up-state New York) and $ 1,300

(Manhattan)

32


Corporation

• A corporation is a separate legal entity, with limited liability, distinct from the

stockholders, directors and officers

– A corporation is said to be a “legal person”

• All 50 states have distinct corporation laws

– In general, corporations are taxable entities

33


Corporation

• Corporations are formed by submitting articles of incorporation to the appropriate state

agency

• Corporations have limited liability; stockholders have no personal liability (beyond value

of equity contribution)

– Exception: piercing the corporate or “limited liability” veil

• business affairs of corporation and stockholders are entangled

• the corporation does not comply with the required legal formalities, e.g. failure to

keep proper records

• The corporation is undercapitalized

– Stockholders of startup corporations are often required to guarantee loans made to

the corporation

• The rules of governance of a corporation are set forth in the corporation’s articles of

incorporation, bylaws and stockholders’ agreement(s)

34


Corporation

• A corporation is a taxable entity (and is not a pass-through tax entity)

• Corporations are managed by a board of directors and officers

– Limited flexibility of management/capital structure

• Directors and officers are liable to the corporation and the stockholders in connection

with the performance of their duties

– indemnifications can be provided in governance documents

• Stockholders can transfer shares unless such transfer is restricted by a stockholders’

agreement or securities laws and regulations

• Incentivized compensation schemes generally thought to be easier to implement (than

for LLCs)

35


“C Corporations” and “S Corporations”

• C Corporations are subject to corporate income tax under the Internal Revenue Code

(and most state tax laws)

• S Corporations are pass-through entities not subject to corporate income tax under the

Internal Revenue Code (and most state tax laws)

36


“C Corporations” and “S Corporations”

37

• The “customary” form of corporate

taxation

• Double taxation

– Corporate income tax

– Stockholder level (taxation of

dividend income)

• Unlimited number of stockholders

• The most popular business entity with

venture capital investors

– Easiest to take public in an IPO

– Easiest/cleanest business entity for

equity incentives (e.g. stock options)

to attract and retain employees

• S Corporations are “hybrids” between

partnerships and C Corporations

• Pass-through tax treatment

• S Corporation must allocate the taxable

income to the stockholders in

accordance with their ownership stakes

• Limitations on stockholders and stocks

– Stockholders must be US citizens or

residents

– Maximum 100 stockholders

– Stockholders must be individuals;

limited exceptions for trusts, estates

and exempt organizations

– Limited to one class of stock

C Corporation

S Corporation


S Corporation Compliance

• S corporation status requires affirmative election filed within short time period with

consents signed by all stockholders

• Risk of inadvertent termination of S Corporation election if:

– a stockholder transfers shares to an ineligible individual or entity (e.g., an IRA)

– a lender is given an "equity kicker" that is deemed to create a second class of stock

– special allocations of profits or losses are made to some stockholder(s), which is

deemed to create a second class of stock

• Distribution of appreciated property by an S Corporation triggers taxation of gain to the

S Corporation stockholders

38


Comparison of Costs: Delaware LLC and Corporation

• The following costs are associated with formation and maintenance of “domestic” Delaware

LLCs and corporations (which do business in New York):

• LLC

– Formation fee: $ 90

– Annual tax: $ 250

– Publication fee (in New York): $ 200 – 1,300 (est.)

– Service agent: $ 100 - 300

• Corporation

– Incorporation fee: $ 89 (minimum)*

– Annual report filing fee: $ 50

– Annual franchise tax: $ 75 or more (up to $ 180,000 maximum)*

– Service agent: $ 100 – 300

* depends on value of assets and number of shares

39


Costs of Delaware Incorporation

• Example:

– A Delaware corporation having gross assets (as determined for federal tax purposes) of

$ 1,000,000 and which has authorized 1,000,000 shares of common stock, par value

$ 1.00 per share, and 250,000 shares of preferred stock, par value $ 5.00 per share, of

which 485,000 total shares have been issued, would have an annual franchise tax

payable of $ 1,400

– A leading service agent charges a fee of approx. $ 100 – 300 to act on behalf of an

entity that does not have a place of business in the state

40


Comparison chart of business entities

41

Sole

proprietorship

LLC C Corporation S Corporation

Formation

requirement

None File and pay fee File and pay fee File and pay fee

Management Owner Members or appointed

managers (flexible)

Board and officers Board and officers

Limited

Liability

No Yes Yes Yes

Taxation Entity not taxed Pass-through - but

can elect corporate tax

Double taxation Pass-through

Funding Sole proprietor

provides capital

Sale of interests

subject to operating

agreement

Sale of stock –

preferred form for

VCs

Sale of stock -

limitations on

investors

Equity

incentives

Not possible Can require more work

than corporations

Easy and clean Possible but less

flexible than C

Corporation


Snapshot: Organizing without a lawyer

• We have all seen startups that were organized without the assistance of a lawyer

• The reasons for self-organization could be:

– To save money

– (False) belief that a lawyer isn’t necessary

• There are many intricacies involved in organizing a specific form of entity and choosing

the right form that serves the needs of a startup

• Most self-organized entities contain significant flaws in organization or documentation

that can expose the entity to 'life threatening" risks, including unresolved disagreements

among founders, uncertain ownership of critical intellectual property, unexpected tax

liabilities, inability to attract and retain employees, and inability to raise equity or debt

capital

• A dollar saved while organizing the business entity could be costly when external

funding is needed to grow the business or the founders wish to exit

• A professional investor will never invest in a company with a flawed corporate set-up

42


Snapshot: Organizing with a lawyer

• Lawyers experienced in advising startups have template formation documents that can

easily be fine-tuned to the circumstances of the specific business

• Lawyers with experience with startup companies know the importance of an open and

candid discussion about fees and are usually willing to negotiate cost effective solutions

for the startup process

• Cost effective solutions can include

– Modest, fixed or capped fees in the early stages of startups

– Equity compensation

• Both pros and cons

43


Conclusion

• The optimal business structure depends on the specific circumstances for the

founder(s), the business plan and the entity itself

• If the business is ready to attract venture capital investors or such funding is anticipated,

incorporation as a C Corporation is generally thought to be preferable

– Trend moving away from conventional wisdom?

• Legal advice is very important to avoid organizing an entity as the wrong business form

– mistakes in the organization process can be costly

• Nevertheless, if the nature of a business’ prospects or goals changes, the form of

organization can be changed by re-organization (merger) to a different form

– Some changes will be more “expensive” than others; e.g. changing an LLC to a

corporation is usually relatively straight-forward, while changing a corporation to an

LLC is often more complex

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Agenda

45

Holland & Knight






Takeaways


Where to organize

• You can organize in any of the 50 states and you do not need to be doing business in

the state of organization

– Thus, any state of organization can be chosen

– Competition between states: Race to the top or race to the bottom?

• Many states require that an entity which is organized in another state must qualify again

as a “foreign corporation” in the state where it is actually doing business

– Such qualification may subject the entity to additional taxes and fees

– Example: a Delaware corporation which is “doing business” in New York would have

to pay

• $225 initially to qualify to do business in New York

• an annual maintenance fee of $300

• $100 - 300 to a service agent (if the entity does not have a place of business in

Delaware)

• additional cost for LLCs: costs to make publication of the organization in New York

newspapers

46


General considerations in choosing state

• The following general considerations are significant when choosing the state of

organization:

– Incorporation, service agent and publication fees and franchise taxes

– Level of corporate service

– Signal effect and recognition factor

– Predictability

• Developed case law

• Frequent updating of corporate statutes

– Factors which are not generally relevant include:

• geographical location of the business

• Income tax rate of headquarters location

47


Where to organize

• Delaware

• New York

• “The rest”

48


Popular states/places for organization

• Popular states/places of organization include the following:

– Delaware

– New York

– The home state

– Others

– Foreign incorporation

• However, the applicable laws of all states or countries where the business is carried out

apply and the entity

– must qualify to do business in other states than the home state

– can be sued in these jurisdictions

– can conduct business in any jurisdiction (in which it is qualified)

– generally must pay income, franchise or business tax in every jurisdiction where it

conducts business

49


Delaware

• Delaware has for many years been the preferred state of

incorporation

– Many venture capital and other investors insist on

Delaware incorporation

– Most lawyers prefer Delaware

– More than 900,000 business entities have their

legal home in Delaware

• more than 50% of all U.S. publicly-traded companies

• 86% of all IPOs in 2011

• 63% of the Fortune 500

are incorporated in Delaware

• Delaware is the preferred incorporation state for companies seeking venture capital

50


Delaware

• Smaller companies should consider whether the benefits of Delaware incorporation

outweigh the disadvantages

– Delaware may offer greater flexibility in governance than other jurisdictions

– Lawyers are familiar with Delaware corporation law

– There may be extra costs associated with an out-of-home-state incorporation, such

as

• required qualification to do business

• New York requirement for LLCs to publish in newspapers that they do business in

New York

• requirement to have a service agent (if there is no place of business in the state)

– Delaware has a franchise tax that is levied on its corporations

• Reincorporating in Delaware to facilitate venture capital investments or an IPO can be

more expensive than incorporating in Delaware from the start

51


Reasons to Choose Delaware

1. Delaware corporate law

• business “friendly”

• protection for officers and directors

• flexible and modern statute

2. Delaware Court of Chancery

• unique corporate law expertise

• no counterpart in the other 49 states

• service-minded and time-sensitive

• experienced judges

• extensive litigation results in predictability

3. State legislature

• high priority on corporation law matters

• Delaware Bar Ass’n recommends and drafts all amendments to the statute

4. Secretary of State

• highly automated

• sophisticated, efficient and service-oriented

• long hours – office open after regular business hours

52


New York

• New York organization may also be considered

• New York has the following advantages:

– New York corporate law is familiar to many

lawyers and investors

– New York is the home state for many

professional investors

– New York is an international center for

financial services

• But, the ten largest stockholders of private corporations

organized in New York are liable for unpaid wages, salaries

and other forms of compensation

– Does not apply to foreign corporations that are qualified

to do business in New York

• New York is not nearly as widely used as Delaware for

tech companies or companies with venture capital investors

53


Home state

• If the entity is conducting business primarily in a single state (the home state of the

founder), the home state may be the most logical state for incorporation

– In the New York metropolitan area, Connecticut and New Jersey are sometimes used

as organizational states for entities where venture capital or institutional investor

participation is not anticipated

• If the corporation does not do business in other states and is incorporated in the home

state, the corporation does not need to be registered or qualified as a foreign

corporation in other states

– Thereby it avoids costs associated with having a service agent, qualification and, in

the case of LLCs organized outside of New York, publication of the qualification

• Home state incorporation may not be optimal if the entity plans to obtain venture capital

funding at a later stage or if it is a candidate for an IPO

54


The Others

• Nevada

• California

55


Foreign incorporations

• Foreign incorporation, for example in a tax-advantaged jurisdiction such as Cayman

Islands or Bermuda, is unlikely to be attractive to a startup company or its US investors

• However, foreign investors may require a non-US vehicle for tax reasons and certain IP

and tax strategies may require use of a foreign corporation

56


Agenda

57

Holland & Knight






Takeaways


Structuring Issues

• Founders should confront and decide certain structuring issues at the time of entity

formation

• For corporations, these include

– Corporate name and trade name

– Classes of stock

– Composition of board

– Stockholder and board voting requirements

– Titles and identities of officers

58


Structuring Issues

• For LLCs, these include

– Name

– Legal provisions governing membership interests, including allocations and

distributions to members (may not be pro rata)

– Management and governance

– Voting requirements

59


Snapshot: Naming Considerations

• Is the corporate version of the name available in Delaware and the home state?

– The entity can for a fee reserve a name while the organization process is ongoing

• Does the name include required “words of limitation”?

• Can the name be “trademark” and “trade name” protected?

• Is someone else using the name in the same or a different industry?

• Is the name available as a domain name?

60


Governance and transfer issues

• If there is more than one founder, governance, transfer and exit issues will need to be

decided as soon as possible

• These include:

– Voting rights and vetos

– Tie-breakers

– Buy-sell or other impasse provisions

– Transfer restrictions

– Exit rights (drag along and tag along)

• Typically covered in a stockholders’ agreement and by-laws (corporation) or operating

agreement (LLC)

61


Snapshot: The Deadlock Problem

• Deadlock arises when directors or stockholders cannot resolve an impasse

– most commonly when there is an evenly divided board or a tie vote among

stockholders

• There is no easy way to avoid deadlock unless you set up procedures in advance to

deal with the problem

– uneven number of directors

– buy-sell provision

– mediation/arbitration

• Important to adopt deadlock breaking provisions early on

– they are nearly impossible to adopt once a conflict has arisen

62


Initial Capitalization

• After the structure is agreed, the founders will issue common stock (corporation) or

membership interests (LLC) and must consider the relationship between equity

percentage ownership and funding sources and requirements

• Both common stock and membership interests represent a fractional undivided interest

in the ownership of the entity

• Valuation, class, preference, dilution and use of proceeds concerns must be addressed

at the time of organization and each financing event

– This topic will be discussed in greater detail in our next NYTECH program

63


Snapshot: Equity Structure

64

Common

Stock

Preferred

Stock

Convertible

Debt + +

Founders, employees,

Board members and

advisors

External Investors External Investors

• Voting rights

• Options

• Vesting

• Equity to industry

experts and

celebrities?

• Dividend preference

• Liquidation preference

• Voting rights

• Redemption rights

• Protective provisions

• Debt convertible into

stock

• No voting rights


Securities Law Compliance

• The United States has very tough securities laws applicable to all sales of stock and

other securities

– The general rule is: No stock can be offered or sold unless registered or exempt

from registration

• Sales to employees, advisers, and investors (including friends and family) can be

exempt so long as a specific exemption is identified and complied with

– There are numerous different exemptions for private sales available, but an illegal

sale can be difficult or virtually impossible to repair

– There are civil and criminal penalties for violation of securities laws

– While the recently-enacted JOBS Act liberalizes the securities law, it doesn't change

some of the basic prohibitions

– Always consult a lawyer before offering stock

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Holland & Knight






Takeaways



• When the business is being organized, or soon thereafter and for the life of the entity,

the founders and investors will also need to consider other significant factors including:

– Financing

– Intellectual Property Rights

• These will be the subjects of our next two classes

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Financing: various stages and needs

Lifespan of

a business

“Idea”

Implementation of

strategy/revenue stage

Execution of idea/

build prototype

Organization

of startup

company

Exit

68

Optimize potential

And operate

Financing

Financing Financing

Financing

Financing


Various types of financing

69

Self

financing

Family

loan

Family

equity

Bank

loan

Angel

financing

Venture Capital

Considerations in seeking financing:

• Debt/equity

• Founder vs. lender/investor

• Retention of control

• Bargaining power

• Economic needs of specific business

• Timing - when to seek funding

• Dilutive effects

Financing Financing


Intellectual Property Rights

• For many startup companies the most important element of the business is the people

and the “ideas”

• In order to commercialize the “idea” it is important that intellectual property rights be

protected

• The startup needs to make sure it is assigned/retains all intellectual property rights and it

is entitled to sell and/or license such rights to third parties

– Agreements with employees

– Agreements with consultants, etc.

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Holland & Knight






Takeaways


Takeaways

72

2. Choosing the optimal form of organization

• The optimal business structure depends on the specific circumstances of the founder(s) and the entity itself

• If the business is ready to attract venture capital investors or such funding is in the near future, incorporation as a C

Corporation is generally thought to be preferable

1. When to organize as a business entity

• There are several reasons why organizing as a business entity is prudent

- Trigger event

- Limit liability, tax efficiency, promote external funding, credibility with third parties, etc.

3. “Incorporation” state

• A business can be organized in any of the 50 states irrespective of whether it does business in the state

• Delaware is the most used state of incorporation for companies seeking venture capital financing

• The home state is popular for entities that only have a local presence and do not expect to seek venture capital

4. Structuring considerations

• The founders must consider certain structuring issues in connection with organizing the business, including

- Choice of name, classes of stock/interests, composition of board/management, voting requirements, etc.

- Governance issues: voting requirements, deadlock solutions, transfer restrictions, exit rights, etc.

5. Retain legal counsel early

• Legal counsel should be retained as early as possible to assist in

- Picking and setting up the optimal business structure

- Protecting the business going forward, including the intellectual property rights

- Ensuring compliance with securities laws and regulations


A Motto for Startups

Finis Origine Pendet*

The beginning shapes the end

*Motto of Phillips Academy, Andover, Massachusetts

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Exit

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Questions?

www.hklaw.com


Acknowledgements

Thanks to Søren Justesen of Copenhagen, Denmark, an international law clerk at the New York office of Holland & Knight, for his substantial assistance in preparing these slides

Thanks to my partner, Marc Reisler, and to Erik Grimmelmann, Executive Director of the New York Technology Council, for encouraging our involvement in the Legal Essentials series

Thanks to my co-panelists, Paul Ellis of the law firm of Paul Ellis Law Group LLC and Glen K. Westerback of the law firm Frankfurt Kurnit Klein & Selz, for their thoughtful review and comments


Thank You!

www.hklaw.com


Frode Jensen

31 West 52nd Street

New York, NY 10019

Tel 212.513.3462

[email protected]