Top Ten Legal Issues for Startups Harvard Business School November 13, 2003 John H. Chory Michael D. Bain

2 Starting a Company: Entity Formation Founder Arrangements Intellectual Property Employment Raising Capital

3 1. Entity Formation Subchapter S Corporation Subchapter C Corporation Partnership Limited Liability Company What Type of Entity Should You Create?

4 S Corporation: “Pass through” tax treatment All owners have limited liability Limited to 75 owners Non-resident aliens and corporate stockholders are not allowed Only one class of stock is permitted (voting differences acceptable) 1. Entity Formation

5 C Corporation: Double taxation All owners have limited liability No restrictions on types of owners No maximum number of owners Permitted to have different classes of stock 1. Entity Formation

6 Partnership: “Pass through” tax treatment Not all owners have limited liability No limit on number or type of owners 1. Entity Formation

7 Limited Liability Company: Pass-through tax treatment All owners have limited liability No limitation on number or types of members VC’s usually won’t invest in LLCs No “tax-free” reorganizations Employee compensation issues Cost and time to administer 1. Entity Formation

8 Become a C-Corp If You Want To: Obtain VC funding Go public Do a “tax free” M&A deal Use equity to compensate employees 1. Entity Formation

9 Where Should Your Company Be Incorporated? D E L A W A R E 1. Entity Formation

10 Ownership: Founders should agree on ownership allotments early, including consideration for property, cash, time and effort Restricted Stock Agreements: Vesting Terms: – vesting up front – remaining vesting schedule – acceleration upon termination of employment – change of control acceleration * Investors may change deal later * 2. Founder Arrangements

11 Other Terms: – restrictions on transfer of shares – lock-up Make sure founders assign all intellectual property rights to the company No founder licenses to the company 2. Founder Arrangements

12 Possible Answers: You People who collaborated with you Former employers 3. Who Owns IP Created Prior To Incorporation?

13 Assignment of Inventions Agreements: Require disclosure of all innovations Assign ownership of innovations to Company Don’t forget consultants 4. Protecting the Company’s IP

14 Institute a Trade Secret Protection Program: Information must have limited availability Its limited availability must give it economic value Must take “reasonable precautions” to keep it secret only disclose trade secret or other confidential business information under nondisclosure agreements implement and follow procedures 4. Protecting the Company’s IP

15 Patents: Broadest form of protection, but most expensive to obtain and enforce Why do you want patents? – offensive purposes- marketing purposes – defensive purposes - satisfy investors Understand the provisional application process and foreign patent process Educate your employees on the process and its importance: –disclosure programs- incentives 4. Protecting the Company’s IP

16 Is company name going to be critical for marketing purposes? –conduct thorough searches –select a protectable name –don’t fall in love with your company name before it is cleared as a trademark –allow time for the process Trademarks : 4. Protecting the Company’s IP

17 Use a well-crafted offer letter: Avoid employment contracts Employment is at will No violation/conflicts with former employer agreements -be aware of existing restrictive covenants 5. Building a Team

18 Invention and Non-Disclosure Agreements Non-Competition and Non-Solicitation agreements –enforceable if reasonable in scope and duration Evaluate Immigration Issues 5.Building a Team

19 Compensation: Employees must get paid Be careful compensating with stock –tax issues for employee or consultant / withholding obligations Equity: Restricted Stock: –best tax benefits for employees –limit restricted stock grants to founders and early employees ISO’s – for employees NSO’s – for directors and non-employees 6. Compensation/Equity Issues

20 Considerations: –avoid family and friends if possible –seek “accredited investors”: – a director or executive officer of the company – a person with a net worth, together with spouse, of more than $1.0 million – a person who has had income greater than $200,000 for the past two years or joint income with spouse greater than $300,000 for the past two years –minimize number of stockholders and transaction costs –vc-friendly terms and conditions –speed 7. Raising Seed Capital

21 Typical Fund Raising Vehicles: Sell Common Stock: –easy –valuation problems –dilution –not attractive to investors 7. Raising Seed Capital

22 Sell Preferred Stock: –valuation issues –expensive –give up lots of control for little money Sell Convertible Debt: –straightforward transaction with low transaction costs –can convert into next round –does not provide a current valuation –can be accompanied by an equity component 7. Raising Seed Capital

23 What are VC’s looking for in an investment? Strong management team – previous home runs Sound business proposition – unique idea – technology/IP advantage – big market – sound strategy to break into, and lead in, the market 8. Raising Money from VC’s

24 Business Plans: Prepare a comprehensive business plan; use realistic financial models Approach a selected number of venture capitalists Find the right venture capitalist: Do they have experience with similar types of investments? Do they take an active or passive management role? Are there competing companies in their portfolio? Are the personalities compatible? Can they help provide contacts for industry relationships? 8. Raising Money from VC’s

25 Liquidation Preferences: –participating preferred –super liquidation preferences (2x, 3x or more) Dividends: –accruing –cumulative –when are they paid? 9. Venture Capital Terms

26 Anti-dilution Adjustments: –weighted average –full ratchet –pay-to-play –carve outs Redemption Rights: –mandatory –optional –when is it triggered? –what price? Covenants and other protective provisions Preemptive rights 9. Venture Capital Terms

27 Carefully select entity Observe corporate formalities: –have good records –hold regular board meetings; keep minutes –properly authorize stock issuances and major contracts Things that could trip you up: –severance payments –accelerated vesting –tax issues –consents 10. Preparing for a Liquidity Event

28 Always Aim To: Keep things simple Minimize transaction costs Maintain flexibility *** Do the right thing now – it will save you time, effort and expense later ***Conclusions