DROR FUTTER JOSEPH FERINO © 2013 SorinRand LLP, all rights reserved 1 Legal Issues for Start-Ups

Disclaimer 2 This presentation and these materials are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. The opinions expressed in this presentation are those of the authors alone and may not reflect the opinions of the firm or any other attorney.

Choice of Entity 3 Should I incorporate? When? Types  Corporation  Limited liability company Main issues  Limitation of personal liability  Tax  Financing strategy  Business management

Corporation? 4 Separate legal entity governed by laws of its state of incorporation (usually Delaware) Limits liability of its stockholders – generally, stockholders stand to lose only their investment amount and are not responsible for company debts Easy to incentivize employees and service providers through options  Generally more tax-advantageous to incentivize employees through equity compensation than similar equity interests in an LLC Double Taxation  Corporate income taxed when received by the company and again when (if) it is distributed to the stockholders  S-Corporations eliminate this “double taxation,” but are subject to specific stockholder eligibility requirements and limited number of stockholders

Limited Liability Company? 5 Some of the same benefits as a corporation  Limited liability of owners More flexibility than a corporation in many respects  Greater discretion with respect to distributions of profits, management and allocation of profits and losses A “pass through” entity (unless equity holders elect otherwise)  Profits and losses flow to equity holders  No double taxation  Equity holders can take advantage of early losses

Choice of Entity 6 Practical considerations  Venture capital firms do not generally invest in LLCs  Most venture capital firms will require an LLC to become a corporation prior to making an investment (this could add additional time and transaction cost to a financing)  Corporation makes equity incentives easier  LLC may be more tax advantageous to founders Ultimately, a fact-specific determination

Early Stage Financing 7 Need for outside funding for operations, growth Sources of financing  First outside dollars may come from friends and family or personal savings  For small financings, angels or friends and family might be a better option than institutional investors Types of financing  Could take many forms depending on the investor  Straight debt, convertible debt or common equity Venture capital investors  Bring experience in your sector and contacts (more than just a check)  Preferred equity

What Should I Care About? 8 Besides the amount of the check, what else should I care about? Preferred Stock carries economic rights and preferences superior to Common Stock, along with certain control rights

Liquidation Preference 9 Preferred stockholders receive a return on shares upon a “liquidation event”  Merger  Sale of substantially all assets  IPO At least the value of their investment (possibly, plus accrued dividends) and/or a multiple (such as 2x or 3x), before common stockholders are paid  Preferred Stock is usually convertible at the holder’s option, so preferred stockholders get greater of (1) liquidation preference or (2) what they would receive as common stockholders After the preferred stockholders are paid, the balance of proceeds is distributed:  To the common stockholders pro rata, or  To the common and preferred stockholders together (“participating preferred”)

Dividends 10 Can be paid only “when, as and if” paid on the Common Stock (i.e., never) Can be cumulative and paid upon liquidation or redemption (like interest)  Guarantees a minimum return at the time of payment

Conversion to Common 11 Preferred Stock converts into Common Stock (usually at, initially, a 1 to 1 basis) Converts at option of the holder, by certain shareholder votes, or automatically, as upon IPO Conversion ratio is adjustable  Common Stock splits, similar events so Preferred Stock retains value – no net economic effect  Anti-dilution protection – protects against future stock issuances at a lower price

Preferred Stockholder Rights 12 Voting Rights Preferred stockholders typically get the right to approve major corporate decisions Board Representation Preferred stockholders typically get the right to appoint Board members and observers Preemptive rights (right of first offer)  Preferred stockholders have the right to participate in subsequent equity issuances on a pro rata basis Information rights Founder restrictions  Right of first refusal on transfers  Non-competition, non-solicitation agreements  Company repurchase right on founder shares

Employment Issues Employment Terms  “At-Will Employment”  Equity Grants  Confidentiality  Non-Competition  Non-Solicitation  Assignment of Intellectual Property Consultants Interns 13

At-Will Employment Except for senior executives, in the US it is rare for a venture employee to have an employment agreement Most employment is “at will,” which means either side can terminate the relationship for any reason at any time Two weeks is a typical notice period, although longer periods are some times found for senior executives/critical employees 14

Equity Grants Employees are often granted equity interests in the company. 3 main forms:  Stock Options  Restricted Stock Grants  Profits Interests (LLC) Main terms:  Strike price  Vesting period  Exercise period 15

Other Employment Terms Confidentiality  Perpetual or term of employment plus a fixed period Non-Competition  Prevents employee from working for a competitor  Courts will not enforce overly broad clauses and non-compete clauses are not enforceable in California  Typical limitations  Duration  Geography  Definition of competitor Non-Solicitation  Prevent former employee from “poaching” colleagues and/or engaging former customers 16

Assignment of Intellectual Property Rights By “default” a company does not necessarily own all IP created by its employees  Patents initially are owned by their inventors Employees are required to assign all IP to their employer and agree to sign any documentation required to:  transfer the IP  file for registration of the IP (example: filing for a patent) Issues to be addressed  IP created after hours  IP created using company assets, but not on company time  IP unrelated to the business of the company 17

Hiring Issues Consultants – even though you call someone a consultant, the law and tax authorities may treat them as an employee (“Deemed Employment”). Misclassifying an employee as a consultant can have significant tax consequences Unpaid Interns – a string of recent cases have made it clear that it is very difficult to hire unpaid interns if they are performing tasks similar to other paid employees and in the absence of an educational purpose. Among the consequences, many unpaid interns are working violation of minimum wage laws 18

Intellectual Property Patents Trade secrets Copyrights Trademarks/Service Marks Trade names 19

Coverage Patents – inventions that meet certain criteria including novelty, non-obviousness and utility Trade secrets - secret processes, techniques and methods employed by a business Copyrights – works of authorship such as books, music, software, photographs and paintings Trademark/Service Mark – the words and/or graphics that a business uses to distinguish its products or services from those provided by another entity Trade Names – corporate name of an entity 20

Duration Patents – 20 years from filing Trade secrets – for as long as the confidentiality of the trade secret is maintained Copyrights – life of the author plus 70 years, similarly long periods for corporate authors Trademarks/Service Marks – with proper “policing,” potentially perpetual 21

Copyrights  Use of © in a circle does not require registration. Can be used any time a work is created  Format is © [Year] [Author]. All rights reserved  If a work is updated, year should include initial year and updates:  © 2011, 2012 ABC Corp  © ABC Corp 22

Trademarks Common Law Trademarks  Do not require registration  Designated by ™ (product) or SM (service) Registered Trademarks  Can only be used for marks that have been approved for registration by the Patent and Trademark Office  Designated by ® Trademark v. Trade Name  One designates a brand. The other than name of a company. Same phrase can be both.  Example: Google today announced the launch of its Google Lawyer™ product.  First usage – trade name, second – trademark 23