Planning ahead for your new tech start-up will pay off big time in the future. Not only will you avoid the frustration of having to undo a poorly conceived corporate structure, but also the costs and unintended consequences could be substantial, and sometimes even crippling. Expensive lawyers and accountants will have to be hired, and the tax costs of using the wrong structure could be disastrous for both the company and its founders.
The best advice we can offer is that the sooner you get a qualified attorney and accountant involved, the better. It is crucial that they both be experienced in the specialized problems of start-ups and growing companies.
Of course, not all businesses require this level of planning. If you are starting up a local dry cleaning store with a couple of employees, then the issues will not be that complicated, and a local accountant may be all that you need. But the aspiring tech entrepreneur faces much more sophisticated legal issues, especially if she expects to obtain outside funding from angel or venture capital (VC) investors.
We have put this guide together because we noticed that there is a lot of questionable advice on the Internet written by people with little or expertise in the area of tech start-ups. Even some of the major publications, such as Inc. Magazine, often give poor or oversimplified advice. One source of information that we have found very useful is the website and blog of Los Angeles corporate attorney Bennett Jay Yankowitz. You can learn more about him with the video entitled Los Angeles Business Lawyer Bennett Jay Yankowitz: https://www.youtube.com/watch?v=7f-cs-h4Fpc. The YouTube page also contains the links to his blog.
So here we go with the most important tips for the aspiring tech entrepreneur.
Set up your Legal Structure Correctly from the Beginning
The limited liability company (LLC) has become a very popular form of business organization since its adoption in most U.S. states in the 1990’s. At the risk of oversimplifying, an LLC is a hybrid between a corporation and a partnership, combining the best attributes of both. Like a corporation, it provides limited liability to its owners (who are usually called members), while, like a partnership, it is not separately subject to income taxation. Instead, the tax profits, losses and gains are passed on to its owners, who report their share of the LLC’s tax items on their individual tax returns. In contrast, a corporation files its own tax return and pays taxes on its income. If it makes a dividend to its shareholders, they are taxed a second time on the dividend income they receive.
Many Internet blog articles will advise you to always use a corporation for a tech start-up, on the theory that VC investors will not fund an LLC. The reality is not so simple. VC investors are a sophisticated bunch, and most will fund a business in the form of an LLC if there are solid business reasons for doing so. Contrary to the opinions of some, tech companies formed as LLCs can duplicate even the most complicated corporate capital structures, with multiple series of “units” (the LLC equivalent of corporate stock) having complex preferences, dividends, conversion rights and the other bells and whistles frequently found in VC preferred stock or convertible note investment structures. LLCs may also have the equivalent of stock option and restricted stock plans and other employee incentivized equity plans.
The one case in which an LLC may not be used is when a company goes public, as the tax laws generally make it impossible to have a publicly traded entity, like an LLC, that is taxed like a partnership. However, with the proper legal and tax planning, a pre-IPO conversion from an LLC to a corporation can usually be made with little or no adverse tax consequences.
To reiterate, whether to form your company as an LLC or a corporation depends on the particular facts of your situation. Usually, these come down to tax issues. An LLC is usually preferable when the business owns real estate or other depreciable assets. In this case, there will probably be tax (i.e., non-cash) losses in the early years when the company has little income but is generating tax losses through depreciation. These tax losses can then be passed on to those investors that put up cash, who will invariably welcome the tax losses, which can then be applied to offset certain other items of income and gain on their personal tax returns. If the capital structure includes debt, an LLC can likewise pass on the deductions generated by the interest payments to its investors. If the company were formed as a corporation, then the losses would remain at the company level, and since the corporation presumably will generate little or no income in its early years, these losses would have to be carried forward.
LLCs do have disadvantages. They are more difficult to set up with complex capital structures, which could result in higher legal fees. And a number of states, including California, impose a franchise or similar tax on the gross revenue of an LLC.
While corporate dividends are subject to double taxation, this is often not an issue for a tech or other type of start-up. When the game plan is to grow the company to position it for a sale or IPO, then dividends are usually not paid because all income generated will be reinvested into the company to drive growth. Furthermore, tech companies typically do not own real estate or other depreciable assets, so there is no need to pass tax losses to its investors by organizing as an LLC. This includes most patents, trademarks other forms of intellectual property (IP), the costs of which generally must be capitalized and for which depreciation and amortization is often unavailable or subject to restrictions.
Finally, it should be noted that an S corporation is almost never suitable for a tech start-up, since an S corporation may not have both common and preferred shares.
Pick the Proper State of Incorporation
Delaware is often recommended as the best jurisdiction in which to incorporate. This is based on a combination of the flexibility of the Delaware corporate laws and the experience and sophistication of the Delaware judicial system in dealing with cases involving corporate law. In addition, Delaware has a separate Court of Chancery to deal with injunctions, restraining orders and other forms of equitable relief. This is especially attractive in case involving hostile takeovers, proxy battles and other critical corporate matters where a judge needs to make highly important decisions in a very short period of time.
However, the “flexibility” and other advantages that many VCs and their attorneys point to are really provisions that work in favor of the VC investors, and not the company’s founders. The fact is that the corporate statutes of many other states, California in particular, have significantly greater protections for all investors, including the founding shareholders. This is particularly the case where the company is likely to be sold or merged. In this case, the problem with Delaware law is that the preferred stockholders have much greater flexibility to sell the company without the consent of the founders and retain most of the proceeds through their liquidation and other preferences.
Issuance of stock usually occurs in a series of rounds, and if not properly structured, can lead to unintended tax problems and other issues. In addition, it is critically important for the founding team to agree on the initial allocation of responsibilities and of equity in the company, and to set up procedures for stock vesting, employment terms and buy-sell rights.
The initial stock allocation among the founders is usually a matter of (sometimes intense) negotiation. Initial stock allocations should be based both on the contributions made to date by each founder, both in terms of IP, services and cash, as well as expectations going forward.
The splits will generally be made based on considerations such as the relative contributions of cash, IP and “sweat equity” by each founder and their duties and responsibilities going forward. It is important to make these decisions as soon as possible after creation of the company, especially if it is to be a corporation. This is because the contribution of property to a corporation in exchange for stock will be treated a taxable gain to the extent that the contributed property has appreciated. However, under Section 351 of the Internal Revenue Code (IRC), an important exception is available. If one or more persons transfer property to a corporation at the same time in exchange for stock, and immediately after the transfer they control the corporation, then the transaction will be treated as a tax-free exchange. Control in this context means control of at least 80% of the combined voting power of all outstanding classes of voting stock and 80% of the shares of each class of nonvoting stock. Lets look at the consequences.
If a founder contributes cash, then there will not be a tax since cash does not appreciate in value. Suppose a founder contributes other property, such as IP, that he created and has a value of $1,000. Typically, IP will have little or no acquisition cost, and thus little or no tax basis, and the founder would then be taxed on the exchange of the IP for stock based on the $1,000 value of the IP less any basis he has. However, if the contribution of the IP were to occur at the same time as the other founders received their stock, then the non-recognition rule of IRC §351 would treat all of the founders’ stock exchanges as tax free, as long as they satisfied the 80% rules immediately after the contributions.
It is also important to try to minimize the value of the stock received by the founders at the formation of the company, especially if, as is often the case, some founders will be receiving stock in exchange for services rendered to the corporation. Services do not count a “property” for these purposes, so any stock issued to founders in exchange for services will be taxable to them as ordinary income based on the value of the stock. This is why it is crucial to issue founders stock as soon as possible after the formation of the company, before the stock has any meaningful value.
Learn about VC Valuation and try to Structure Equity Rounds over Time as Capital is Needed
It is never too early to start thinking about future equity rounds. Buy and study one of the several good books on VC and start-up valuation. The key to maximizing the equity retained by the founders is to plan for future equity raises and not to raise more money at any given round that is needed for the next stage of growth of the company (with a reserve to cover contingencies of course). Facebook is an example of how proper planning enabled the company to raise very large amounts of capital in a series of VC rounds while preserving a large percentage ownership for Mark Zuckerberg and the other founders.
Agree in Writing on the Responsibilities and Rights of the Founders
This is also the time to fix other key aspects of the deal among the founders:
- Make sure that everyone agrees in writing that all IP related to the company’s business has been contributed to the corporation and is property of the corporation.
- Each founder should have an employment or consulting agreement and an agreement covering the vesting of his stock
- The duties and responsibilities, including titles, of each founder should be detailed in her employment or consulting agreement.
- There should be a buy-sell agreement giving the corporation and the other shareholders the right to buy a founder’s stock if he dies, becomes disabled, leaves the company or wants to sell to an outsider. There should be detailed provisions governing the valuation of the stock in the case of death or disability or an early exit from the company. In the case of a sale to a third party the corporation (or the other shareholders) should have a right of first refusal.
- Consider also the use of “tag-along” rights, which give all shareholders the right to sell their stock if a controlling shareholder decides to sell her stock to a third party.
- Founders should usually be given restricted stock that vests over time. This is usually tied into the termination provisions of the employment agreement. While the details are frequently subject to intense negotiations and can differ substantially from company to company, a typical provision might be a three-year employment contract with stock vesting equally over 36 months. If the founder/employee were terminated early, he might forfeit some or all of his unvested stock, depending on whether the termination was or was not for cause.
- To avoid adverse tax consequences, restricted stock should usually be accompanied by an IRC §83(b) election.
Make sure that all Founders, Officers, Employees and Consultants have a Signed Employment Agreement with Key Company Protections
Every founder, officer, employee, consultant and should have an employment or consulting agreement or other written agreement covering the following:
- An acknowledgement that all contributions to any IP of the company remain property of the company, and constitute work for hire.
- Be careful of agreements for the payment for services solely with stock or options—these may inadvertently be used by the IRS to assign a high valuation to the corporation’s stock based on the value of the services. If possible, include some cash compensation or deferred compensation as well.
- Include a strict confidentiality clause covering all information and property of the corporation.
- Include a proprietary information clause making it clear that all computer records, mailing lists customer lists and the like are proprietary information and property of the company.
Furthermore, if a founder has another job, it is important to check the terms of any employment agreement with the other employer to make sure that the founder is entitled to work for or participate in the company.
Finally, be careful of using consulting agreements for founders or employees who will be working full time hours and have no other jobs. These arrangements are at risk of being re-characterized as employment arrangements, which would make the company liable for back withholding taxes and possibly other amounts, such as workers compensation insurance.
Implement an Option Plan Before Seeking Outside Funding
It is generally better to have an option plan in place before seeking VC funding, as VC’s are less likely to restrict an already outstanding plan as opposed to the creation of a new plan. Depending on the industry, a pool of 15% to 20% of the total stock is acceptable.
An experienced attorney can provide you with a plan that allows for stock options, restricted stock, phantom stock and other forms of incentive compensation with maximum flexibility. Be careful, as each has different tax treatment. For instance, incentive stock options (ISO’s) have no tax impact at time of grant but must meet a number of conditions to qualify for this favorable tax treatment, and can not be used for consultants. If the exercise price of the option equals or exceeds the fair value of the stock at the time of grant, a non-qualified option will generally not be taxable on grant and will be much more flexible because it will not be subject to the ISO rules.
Be Careful with Deferred Compensation
In 2005 Congress enacted Section 409A of the IRC, an extremely complex and far reaching provision governing deferred compensation. The IRS regulations under Section 409A are even more complex. The purpose of these provisions was to cure perceived abuse of corporate executives who deferred large compensation packages until their retirement years, when they would be taxable at a lower rate.
Section 409A imposes sever penalties on non-qualifying deferred compensation, most notably making the compensation taxable in the year of grant plus a 20% penalty tax.
There are a number of exceptions to Section 409A, including those for qualifying pension plans, stock option and restricted stock plans, and employee benefits such as vacation, sick leave and disability pay. However, the regulations are exceedingly complex, and thus any form of deferred compensation plan or program should be reviewed by a qualified attorney.
Other IP Issues
There are other issues to consider concerning the company’s IP:
- It is possible to mitigate some of the initial tax issues relating to the initial valuation of the company, discussed above, by having the founders retain ownership of the IP and license it to the company. However, this will make it more difficult to raise VC funds, as the company’s ownership of its IP is usually considered a prerequisite.
- Secure your Internet domain name for your brand, and all variations (.com. .net, etc.) as soon as possible.
- Apply for trademark protection for your brand name and logo as soon as possible. A later re-branding because of a trademark conflict can be expensive and time consuming, and costly in terms of lost marketing identity.
Selling stock to friends and family, angel investors and VC investors all require compliance with the Federal and state securities laws.
The best protection to the company from a claim that it violated the securities laws is to provide potential investors with a complete disclosure package. The level of disclosure will depend on whether any investors are non-accredited investors. Accredited investors are generally wealthier: they include persons with net assets (exclusive of primary residence) in excess of $1 million, annual net income of at least $200,000 (or $300,000 combined with their spouse), and trusts with assets of at least $5 million. The idea is that accredited investors can fend for themselves and can therefore negotiate directly with the company to receive the level of disclosure that they desire.
A complete disclosure package will usually include the following elements:
- A thorough discussion of the company’s business plan. This can be a formal business plan, though more common these days is a detailed pitch deck.
- Financial projections for the next several years, plus a clear explanation of the assumptions used to create the projections.
- Historical financial statements, if material.
- Detailed risk factors.
- A subscription agreement and questionnaire to determine the suitability of the investor for the investment and, if applicable, the investor’s accreditation.
Some or all of the above may be in the form of a detailed private placement memorandum, which is advisable if the offering is to include non-accredited investors. This is because the company is required to make to each non-accredited investor the types and levels of disclosure similar to what would be in an IPO prospectus.
Two recent developments will substantially alter the way in which tech start-ups raise capital in the future. Both are a result of the Jumpstart Our Businesses Startups Act (JOBS Act), signed into law in April 2012. The first was the elimination of the restriction on general advertising and general solicitation on offerings made solely to accredited investors. These offerings may now make full use of the capabilities of the Internet to reach potential accredited investors.
The second, not yet implemented, is a new regulatory scheme allowing equity crowdfunding of a company of up to $1 million per year. Crowdfunding, on sites such as Kickstarter and IndiGoGo is currently limited to artistic and charitable projects, where the funders do not receive stock or other equity in the project or company funded. The JOBS Act directed the Securities and Exchange Commission to develop rules for registering crowdfunding portals—websites for listing equity crowdfunding offerings. The SEC has issued detailed proposed rules, which are currently awaiting adoption.
Developments in this area, including Internet offerings and equity crowdfunding, can be followed on the Facebook page of Los Angeles Business Attorney Bennett Jay Yankowitz and his Yelp page.
Standardize your Contracts, Especially Customer Contracts, and the Terms of Service on your Website
Standardizing the company’s key contracts at an early stage can save money down the road in expensive attorney time. And don’ forget to implement proper website terms of service. While these often appear to be boring boilerplate, they contain crucial disclosures and liability limitations and must be carefully crafted by a qualified attorney. In addition, one or more executives should read and become familiar with the terms of service of the top several competitors of the company to make sure that the attorney drafting the terms of service does not miss any key business area.
By carefully planning ahead, the founders of a tech start-up can ensure that their company’s legal structure and capital stack make future fundraising rounds easy and on terms that will maximize their equity in the company as it grows.