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Legal Issues for Start-Ups. Merrill M. Mason December 2, 2010. Steve Jobs, founder of Apple and Pixar:.

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Legal Issues for Start-Ups

Merrill M. Mason

December 2, 2010


Steve Jobs, founder of Apple and Pixar:

“The thing that drives me and my colleagues both at Apple and Pixar is that you see something very compelling to you and you don’t quite know how to get it, but you know, sometimes intuitively, it’s within your grasp. And it’s worth years of your life to make it come into existence.”


…and Then On the Other Hand…

“Starting companies are like having babies –

fun to conceive but hell to deliver.”

-- Anonymous


Role of the Corporate Lawyer

Legal Advisor

Business Advisor

Value Adder

Voice of Reason

Introducer

Sounding Board

Confidant


Planning for the Future

Making Initial Decisions

Forming Legal Entity

Issues During Start-Up Formation

  • Choice of Entity

  • Incorporation jurisdiction

  • Board

  • IP Assets

  • Tax Issues

  • Founder’s Equity Allocation

  • Incorporation

  • Bylaws


Choice of Entity

Considerations

  • Continuity of existence

  • Ease of transfer of ownership

  • Easier to raise capital

  • Separate entity from owners

C Corporation

S Corporation

  • Regular corporation meeting IRS test

  • Difficult choice for startups

Limited liability for stockholders

LLC

  • “Incorporated Partnership”

  • Tax issues in liquidity events

  • Flexibility in operating agreements


State of Domicile

Delaware

v.

Other jurisdictions

  • Developed case law

  • Business-like attitude

  • Willingness of counsel to provide opinions

  • Ease of governance

  • Differences on specific points of law

  • Local allegiances

  • Administration issues


Process of Incorporation

File Charter

  • Corporate Name – Need for Distinction

  • Par Value of Stock – Significance

  • Initial Officers and Directors

  • Adopt Bylaws

  • Payment for Stock

Charter is a public document

Follow up on organizational matters

  • Appoint Board

  • Issue stock

  • Foreign qualifications

  • Tax ID number


What are bylaws?

  • Rules of governance “pulled” from state statutes

What do bylaws address?

  • Officers, Directors – election, meetings, authority

  • Organization of Board – special committees

  • Stockholder meetings

What may be included?

(contract v. charter v. bylaws)

  • Share transfer restrictions to control shareholder pool

  • Indemnification to protect Board members

Forming Legal Entity: The Bylaws


A Critical Asset: The Board of Directors

  • Number

  • Outside Directors

  • Role/Level of Involvement

  • Compensation


Founders’ Equity

Taxes

  • Allocation and vesting of Founders’ equity

  • Dilution v. protection of Founder Interests

  • I.R.S. Section 83(b) Elections

  • Importance of Timing and Consistency in Valuation of Stock

  • Avoiding Taxable Income

Going Forward Issues

  • Identification & Perfection of IP Rights

  • Assembling management team – identify needs – cash and equity compensation

IP Assets


Start-up Legal Mistakes - People

  • Improper or non-existent non-compete and invention assignment agreements.

  • Employment agreements with out-of-market terms for severance or other items.

  • Inappropriate use of titles (too many VP’s who aren’t really VP’s).

  • Outrageous nepotism.


Start-up Legal Mistakes - Capitalization

  • Issuance of stock (as opposed to options) to non-founders.

  • Establishing unreasonable valuations by selling small amounts of equity at high prices.

  • Having dozens of small investors.

  • Selling preferred stock in small amounts resulting in rights and preferences that need to be revoked when a venture round comes together (and the preferred is converted to common).

  • Not establishing an option pool.

  • Running afoul of securities laws in issuing stock.


Start-up Legal Mistakes – Corporate Governance

  • Not establishing a board of directors.

  • Not having bylaws.

  • Not taking minutes and recording them.


Start-up Legal Mistakes - Customers

  • License agreements with toxic terms (e.g. rights to source code).

  • Agreements to provide maintenance or other services without getting paid.


Start-up Legal Mistakes – Technology and Intellectual Property

  • Using open source code in a proprietary product requiring it to also become open source.

  • Poor or non-existent patent writing (and strategy).

  • Failure to maintain patents.

  • Failure to file international patents and maintain them.

  • Poor license agreements for in-licensed technology.

  • Out licenses with partners which give rights away without compensation. (Selling the company w/out selling it.)


Start-Up Legal Mistakes - Other

  • Privately held company bad habits on the balance sheet (e.g. cars, planes, rental property).

  • Related party transactions for real estate or any service.


S corp

C corp

Option pool

Founders

Vesting

Restricted Stock

Incorporation

Executive Summary

Business Plan

Intellectual Property

Common Stock

Preferred Stock

83(b) Election

Dilution

In/Out License

Spin-Out

Buzz Words


. . . and Then What . . .

“Only one thing is certain about a new venture:

It’s going to turn out very different from its business plan.”

-- William Congolton, Venture Capitalist


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