1 Business Lifecycle: Forming an Entity, Raising Capital, and Business Planning Todd Krieger & Cyrus Daftary 2015 Makeup Class
2 Agenda l Forming an entity l Raising capital l Business planning l Insurance l Bankruptcy l Questions and answers
Eli Wants to Start His Business §Visits your office and wants help forming his entity. §Where do you start? l Find out more about the business l Business plan? 3
4 Business Entity / Incorporation §Planning for the future: l Succession planning - who will replace your programmer? l Partial dissolution - what if a partner wants to be bought out. l Future financing - can you plan on going from a sole proprietorship to a publicly-held corporation and what happens in between?
5 Issues to consider l Taxation l Liability shield l Likely source of financing l Number of owners l Types of owners l Types of distributions l Likely exit scenario
6 C Corporation l Liability protection for owners l Subject to double taxation – at entity level and on distributions l Distributions of property to owners are taxable l No limit on number or type of owners l Appealing to venture financing sources l Some exit transactions can be structured in a tax advantageous way (tax free merger)
7 S Corporation l Liability protection for owners l Subject to single level of taxation – no tax at entity level but tax paid by shareholders l Limit on number of owners (100) l Limit on type of owners (individuals only; no foreign persons) l Many financing sources cannot participate (i.e., venture capital funds) l Some exit transactions can be structured in a tax advantageous way (tax free merger) l Limited to one class of stock (other than non-voting stock)
8 LLC l Liability protection for owners l Subject to single level of taxation – no tax at entity level but tax paid by owners (members) l No limit on number of owners l No limit on type of owners l Unappealing to many financing sources – LLCs likely to generate UBTI and be engaged in US trade or business l Generally, no ability for tax free exit transactions l Distributions of property to owners are not taxable transactions l Not as well received by the institutional investing community Not normally used for venture backed businesses l Documents may cost more to prepare as they tend to be ‘non-standard’
9 Limited Partnership l Liability protection for some, but not all, owners (limited partners) l No liability protection for general partner l Subject to single level of taxation – no tax at entity level but tax paid by owners (partners) l No limit on number of owners l No limit on type of owners l Unappealing to many venture financing sources – likely to generate UBTI and engaged in US trade or business l Generally, no ability for tax free exit transactions l Distributions of property to owners are not taxable transactions l Not used in many contexts, but common for private equity funds
10 General Partnership l No liability protection for partners l Subject to single level of taxation – no tax at entity level but tax paid by owners (partners) l No limit on number of owners l No limit on type of owners l Unappealing to many venture financing sources – likely to generate UBTI and engaged in US trade or business l Generally, no ability for tax free exit transactions l Distributions of property to owners are not taxable transactions l Public filings are generally not required l Not widely used.
11 Filing Process A.Corporation (S or C) – Certificate of Incorporation/Articles of Organization; foreign qualifications B.LLC – Certificate of Formation/Certificate of Organization; foreign qualifications C.Limited Partnership - Certificate of Limited Partnership; foreign qualifications D.General Partnership – no filing required; may file a “doing business certificate”
12 Raising Capital: How does Eli fund the venture?
13 Debt Financing §Bank loans l Unlikely to be obtained unless company is already financed l Avoid personal guarantees §Convertible Debt – Best early stage financing vehicle l Promissory notes that convert into preferred stock, once a financing occurs l Avoids valuation problems l Can be used in angel or friends and family financings l Simple; low transaction costs; minimum negotiation
14 Friends & Family §Limit number of investors §Seek accredited investors only §Structure (stock vs. convertible debt) §Valuation issues
15 Angel Investors §Structure (avoid preferred stock) §Try to avoid valuing the company §Avoid onerous terms that might prevent a venture capital financing
16 Venture Capital §VC Requirements l Strong management team l Unique idea l IP advantage l Big market §Terms l Preferred Stock (liquidation preference, dividends, anti- dilution, etc.) l Control (at board and stockholder levels; contractual rights)
17 Other Sources §Government Grants §Strategic Partnerships
18 Securities Law Considerations – Selling Unregistered Securities §General Rule §Number of Investors §Accredited Investors vs. Non-Accredited §Avoid general solicitation or advertising l OK if no non-accredited investors and take reasonable steps to verify accredited status l Subject to additional rulemaking §Consequences of violations l Rescission rights l Could prevent or delay future financings
Jumpstart our Business Startups Act §JOBS act passed in 2012 §Facilitates equity based crowdfunding and reduces some small investor restrictions §https://www.indiegogo.com/ §Different from rewards based crowdfunding 19
Practice Pointer 20 Participants have little legal recourse if the project fails or they don’t get their reward Project may not be completed Participants need to protect their IP http://www.insidermonkey.com/blog/the-5-biggest- kickstarter-scams-that-swindled-backers-donations- 333225/ http://www.kicktraq.com/projects/
21 Intellectual Property Protection §Patents, trademarks, copyrights, trade secrets §Ownership of IP l All IP must be owned by the company §Protection of IP l Confidentiality Agreements l Employee Invention and Non-Disclosure Agreements; Consultant Agreements
23 Scenario – Giving out Shares §Prior to incorporating, Eli’s Tortes has limited $$. §They offer vendors written shares in the upcoming entity in lieu of payment. §100 shares to the flour vendor. §200 shares to the repair company. §50 shares to the delivery service. Eli Distributes: §15% share to the web page designer. §10% share to the landlord §5% share to the sugar vendor. Jason Distributes: §What happens after they incorporate, business goes well, and the vendors want to cash in their shares? Eli’s Tortes
25 Isn’t Business Planning The Client’s Issue and Not Related to the Lawyer? §By understanding the client’s B-plan: l Better serve clients / company by seeing the big picture l More opportunity to provide insight l Expand legal services for client §More likely to notice potential legal pitfalls. §Protect your own interests: l Will the client be able to pay their legal bill? §Law firms use business plans too!
26 Why is a Business Plan Necessary? §It is not adequate just to have a good idea. A new venture needs: l A strategy / long term plan l Capital l Good management l Industry contacts and luck §Formal plans are often required to obtain financing §WSJ 1/07: “Do Startups Really Need Formal Business Plans?” l A business plan does not need to be a formal 60 page, 6 month project l Analysis, planning, vision, and communication are essential for any venture http://www.youtube.com/watch?v=zhnEjxsjjuA
27 Technology Start-up Companies Have Many Challenges §Market demands quick innovation l Today’s technology idea is dated technology in a year; l Patents; l Legal constraints can be a minefield; l Technology licenses; and l Regulatory and safety approval. §There may be more barriers to entry than a decade ago.
28 Business Plans Should Create a Roadmap l Executive summary l Core strategy defining product l Identifying the market opportunity / niche l Competition / threats l Revenue and expense projections l Sources of capital l Short and long term plans l Management team
29 Red flags in a business plan §Get rich quick schemes l “Someone will want to acquire the business after we get it running.” l “We’ll devote time to this until the IPO and retire young.” l “We do not have time for market research - I have heard about this enough on TV. If we do not bring this idea to market soon, someone else will”
30 Red flags in a business plan (cont.) §Risks: l All of the intellectual capital is in one person. l Reliance on uncommitted resources. (“my cousin said that he would host this for free,” or “I can get a free billboard from a brother-in- law.”) l Management has had no experience. l Management compensation is not anticipated as an expense.
31 A few fundamental questions §Realism test: l How did you create your sales projections? l What will you do if sales do not meet projections? l How is this different from the competition? §Infrastructure test: l How will customers learn about your product? l Who will fulfill orders or do the work?
32 Client Example §Client calls up with a vague idea and wants to schedule a meeting. §Client and colleagues spend hours developing a ‘mission statement’ instead of business plan. l No idea of target market l No plan to market services §Idea falls apart within a month. The Dream Team
33 Client Example #2 §Clever idea, but perhaps not unique. §Client wants legal documents ASAP l Non-disclosure agreement l Incorporation documents l Contracts for: Customers Programmers Employees Content providers §Problem - he has not even figured out his business plan. What does he really need? Cart Before the Horse
34 Client example: Challenges Facing a Start-up (Part 3) §Interesting idea but esoteric. §One person’s idea, others have a cursory understanding. §Does the programmer cede his idea to his corporation letting others enjoy the fruits of his labor? §What do the others have left if the programmer leaves? One Founder’s Idea
35 Client example: Challenges Facing a Start-up (Part 4) §Clever idea. Client asks everyone’s opinion in an effort to get private investment. §Decides a confidentiality / non-disclosure agreement would be helpful. §Can he/she have friends / family sign non- disclosure agreements after the fact? §What if his/her idea is not unique and already public domain? “Cat is out of the bag”
36 Insurance Introduction How does the entity protect themselves from a catastrophic loss?
37 Insurance Counseling §You do not have to be an expert on insurance law to counsel a client doing business online - just know the potential risks. §Understand the basic elements of the policy and look for potential exclusions that might hurt your client.
38 Insurance can Protect a Client against Bankrupting Claims §Limelight Productions, Inc. v. Limelite Studios, Inc. (60 F. 3d 767 11th Cir. 1995) l Successful TM claim and profits were awarded to P. l Insurance company was required to indemnify D for all profits awarded to P. l Justification: Insurer knew terms of Lanham Act when the policy was drafted.
39 What Might not be Covered? §Computer network liability §Breach of security §Crime and the Internet §Errors and Omissions §Intellectual property infringement
40 Suggested Minimum For an E-Commerce Site §Libel §Unauthorized access (security) §Viruses §Intellectual property infringement §Web site failure - loss of data §Product liability (if applicable) §General liability (contractor is injured at client site)
41 Other Key Requirements §Negligent acts §Errors and omissions §Breach of duty §Geographic scope of everywhere you do business - including internationally. l What could go wrong and how much could it cost?
42 Some Insurance is not Standardized §One size does not fit all - attorneys must be vigilant. §Every business has different needs §Is the policy appropriate?
43 General Liability Policies & I.P. §Commercial general liability (CGL) coverage policy (the most common): l Advertising injury. l “injury arising out of misappropriation of advertising ideas or style of doing business,” or “infringement of copyright, title or slogan.” §Does this include online activities?
44 General Liability (cont’d) §Few cases address the limits of advertising injury: l P.J. Noyes v. American Motorists Ins. Co (855 F. Supp. 492 D. N.H. 1994). Insured used P’s TM in its own advertising. Insurer had a duty to defend and provide coverage for claim of: –Common law TM and unfair competition. –False designation of origin and misrepresentation.
45 Not all I.P. Claims are Covered §American Economy Ins. Co. v. Reboans, Inc. (852 F. Supp. 875 N.D. Cal. 1994). (minority opinion!) l Insured was sued for selling counterfeit products. Fed TM infringement, Fed counterfeiting, false representations and designations of origin. l Court said misappropriation was not covered and a TM is not an advertising idea or style of doing business - copied products, not ads. l No reasonable expectation of coverage.
46 Business Owner’s Liability Coverage §Advertising injury: “infringement of trademark, service mark, or trade name…in connection with goods, products, or services sold, offered for sale, or advertised by the insured.” §Parameter Drive Software Inc. v. Mass. Bay Ins. Co (25 F. 3d 336 6th Cir 1994): l false designation of origin and unfair competition are included in advertising injury.
48 Reorganizations §Important to recognize when to things are bad §IRC 368 October 18, 2000 In Stable Condition The latest earnings reports carry more weight for the Internet Economy than any that have come before. The markets are in disarray, and deep currents of uncertainty run through once- confident companies.
49 Introduction to Bankruptcy §Federal law (11 USC 101) designed to give debtors a ‘fresh start.’ l Article 1 section 8 clause 4 of the constitution gives Congress the authority to establish bankruptcy law. §Designed to fairly balance the interests of the overwhelmed debtor and the creditor(s).
50 Key Forms of Bankruptcy §Chapter 7: complete liquidation of assets and discharge of (almost) all debts. §Chapter 11: reorganization to extend and / or reduce debt. §Chapter 13: provides 36-60 months for repayment of secured debts (and a percentage of unsecured debts). Not available for corporations. Must have a regular income. §http://www.scu.edu/law/FacWebPage/Neustadter/article9/main/commentary/15.html
51 Most Failing e-Business Don’t Have Many Creditors §40 dot-coms went out of business in December, 2000. §Total cost to investors: >$1,500,000,000. §Only ten filed for bankruptcy. §The rest paid their bills and closed their doors. l No bank loans. l Few assets.
52 After the Funding is Gone, What Remains? §Intellectual property: l Trademarks; l Domain names; l Patented processes; or l Trade secrets. §Customer lists (be careful about privacy issues). §Net operating loss. §Lease & equipment. §Liquidity if shares are public.
53 Risks to 3 rd Parties §No payment for products or services. §Cancelled executory contracts l Scramble for alternative suppliers. §No more product support or updates. §Projects may be left incomplete. §Assets or obligations tied up in bankruptcy proceedings.
54 Practical Hints §Ensure the company’s cash burn rate is monitored and understood. §Use independent accounting / auditing services. §Do a D&B or other search to assess the viability of a third party before starting a business relationship. §Consider the possibility of bankruptcy in any contract. §Secure the assets in a transaction when appropriate (Article 9). §Contemplate an exit strategy when the business is first formed – not when it is failing.
56 Entity Handout Type of Entity Liabilit y Protecti on Tax Number of owners Type of owners Good for VCs? Tax free exit? Distributi on of property taxable? C Corp YX 2 Yes S Corp YX 1<100yesNoYes LLC YX 1 No Limited Partners hip Y/NX 1 No General Partners hip NoX 1 No