Are you planning a for-profit company or a nonprofit?When men are pure, laws are useless; when men are corrupt, laws are broken.
—Benjamin Disraeli
From the moment someone first contemplates starting an enterprise around an idea, issues immediately arise involving law, liability, and eventually taxation. In the current environment, getting legal things wrong can be very damaging; only a collapse of your market can harm your enterprise as badly as stumbling into legal trouble. Few companies fail because of legal troubles alone, but if you are sloppy or lazy on legal issues, sooner or later you will pay a price. If you are starting a company, you have to be conversant enough in all the diverse elements of business law that you do things right the first time and make good decisions from the standpoint of legal issues. You don’t have to know everything in this area. You can’t; that’s what lawyers and specialists are for. Lawyering is not a place to waste money, but neither is it a place to scrimp unwisely.
There are three high-level things you need to learn and manage on your own. Professionals can help you with these things, but no one can or should do them for you:
1. Define the key issues. Basically, you have to decide which factors you should worry about. This means defining issues that can lead to major problems in the future and knowing how to prevent them—which means basically knowing when and how to ask for help.
2. Find the resources. You should know where to go for more information and effective professional resources.
3. Choose wisely. Which legal issues are most important for your company is not just a question of technical issues. In the end it is about philosophy and judgment. Some lawyers will help you think through these decisions, whereas others want to stay safely with the mechanics and leave strategy to someone else. Never abrogate to your lawyers your responsibility to define key issues and make good decisions. Your attorneys can advise you, but in the end you must make the decisions. After all, the lawyers work for you. You don’t work for them.
There is no end to the resources covering the issues of business law that will affect you as you start an enterprise. This chapter is no place to try to reproduce them. One handbook every start-up entrepreneur should have handy and consult often is Constance Bagley and Craig Dauchy’s Entrepreneur’s Guide to Business Law.1 It has 17 detailed chapters on all the key areas of law affecting entrepreneurs. Whenever you deal with attorneys and legal matters, you save time and money in the long run and get a better result if you educate yourself on the fundamentals of the area of business law that is at issue. The best reference we know for learning the basics of a legal area is Business Law Today by Roger Miller and Gaylord Jentz.2 Below are some of the major subject law areas of concern to start-up entrepreneurs. Think of it as a worry list: a checklist of sorts for the different kinds of things you will have to cover adequately sooner or later. Each area needs proscriptive thinking to head off difficulties, and each regularly will require judgment calls and often tough decisions on your part. If you don’t find yourself affected in all these areas as you launch and start operating, you should worry.
You need to have a good corporate attorney when starting a business. This is not a place to cut costs and handle everything yourself. There is no reason it should cost a lot for what you will need in the early days. What will the lawyers do? Everything from advice to incorporation mechanics, to drafting and closing agreements, to getting you out of trouble. Most of all, a good attorney will focus on keeping you out of trouble in the first place and protecting you from risks. Good attorneys think an ounce of prevention is worth a pound of cure.
1. Where do you find them? Referrals are by far the best: directors/advisors, people you know, investors. There are directories, but you can spend a lot of needless time screening candidates from directories instead of checking out referrals from people whose judgment you trust. Always interview more than one candidate, preferably at least a handful. First encounters—consultations—should be at no charge, usually lasting at least an hour. They have the form of a getting-to-know-each-other interview, but they also should be opportunities to ask questions about substance and technical issues. You can learn a lot about your issues in these meetings as well as about the attorney. If you don’t learn much, keep looking.
2. What are you looking for?
a. Competency. Can you work with them?
b. Personality. Are they compatible with you and your operating style? Are they practical and entrepreneurial?
c. Prompt, responsive, and timely. Do they get things done before the last minute? (Many don’t.)
d. Reputation. Check references, especially with other clients. What is their street reputation?
e. Experience/expertise. Do they have technical knowledge of your field? Do they understand start-ups?
f. Litigation experience. Attorneys who have prosecuted or defended clients in court are more sensitive to how things will play out and include this in their strategies and drafting of documents.
g. Size of firm. You often get more personal attention from a small firm, but the resources will be thinner. Large firms have an incredible depth of resources, but they can be impersonal and unresponsive to small clients who don’t affect their bottom lines, and they can be risk-averse. Also, their rates are often higher. Be sure you know who will do the work within the firm: how much by associates and with what review by more senior partners.
h. Contacts. Do they know potential investors and advisors well enough to introduce you, and will they do that?
i. Rates (you get what you pay for) and terms.
3. How do you engage one? Any attorneys you seek to engage will first check to see if they have a conflict because of past or current relationships with other clients who might have conflicting confidentiality needs or end up opposing you in the future. Define expectations on both sides explicitly up front. Get agreement on roles and how you will work together. Negotiate. (You don’t get what you don’t ask for.) Will they offer special terms such as lower rates and/or deferrals of all or part of their billings until you raise money? Will they take part of their bills in equity? Will they work with you as you go, helping you contain costs through things such as budgets or not-to-exceed arrangements and having you do some of the preparation and drafting? Will they offer flat fees for routine matters? Always get engagement letters, which are essentially service contracts setting out the terms of the work and payment, and review budgets with them frequently. You’re poor and starving—resist retainers.
4. How do you manage them? Manage time carefully. Don’t give open-ended projects or mandates. Negotiations and contracting can be budget busters; tightly control negotiations with other parties that involve your lawyer. There are some ways to keep lawyers from turning negotiations into major make-work projects for themselves. Not-to-exceed arrangements are valuable when you can get them, though often when the cost is capped, the scope of work shrinks and you can end up getting less work than is needed to do the job properly.
Prenegotiating the business points with a counterparty before going to the lawyers and memorializing the points in a nonbinding term sheet3 is usually a good practice. Give the term sheet to the attorneys with defined limits on how they will turn them into agreements and close them. Sometimes attorneys have template documents or checklists for conventional transactions. Get them early and use them. Offer to assist in the preparation and drafting. Limit the number of back-and-forth reviews. Nothing says that you can’t create documents or negotiate deals for yourself to save money, but you should always have final products reviewed and blessed by your attorney.
Always remember that you manage your attorneys, they don’t manage you. Keep straight the distinction between business issues and legal issues. Always consider both. If you have good attorneys, they generally will assign themselves the role of your personal worrywarts. This is a good thing. It leaves you free to focus on trade-offs and judgment, confident the attorney will call important issues to your attention. However, you can have too much of any good thing if you haven’t defined roles properly at the beginning or have not chosen your attorney wisely. A common problem: Some attorneys can fall into a habit of bringing up risks beyond all sense of materiality and then offer to spend your money to protect you from them. Where prudence ends and overkill on lawyering begins is impossible to define; it’s one of those things you have to recognize when you see it. The best way to handle this is to confer and consult, and jointly arrive at reasonable balances of risk and cost/caution. In the end you should decide, not the attorney.
Whether you are planning a for-profit or nonprofit, there are several reasons why incorporating your enterprise is almost always a good idea:
1. Getting sued is an ever-present risk, and the ingenuity of enterprising tort lawyers in inventing new classes of liability claims shows no signs of running low. When you operate as a sole proprietorship—that is, as an individual operating in your own name—you are fully liable for all obligations and risks involved in the business, both financial and legal. This means that at any time you could find all your family’s personal assets fully in jeopardy. The same is true of unincorporated partnerships. All state laws provide several options for incorporation to let individuals form a business and reasonably isolate themselves from these legal risks. One or more people can own a corporation, but in most states more than one person is required to incorporate (the incorporators). This can be anyone, an owner or otherwise.
a. In essence, the law considers a corporation a legal person separate from its owner or owners. So long as you honor certain structures and practices, the courts look to a corporation only to fulfill debts and bear legal responsibility for its actions. Caution: In certain circumstances courts will reach through the legal isolation of the corporation to you as share-holders—this is called piercing the corporate veil—and put your personal assets at risk. There are a number of practices you should honor to prevent this. For example, maintain records of board and shareholder meetings and actions, keep accurate capitalization records, and keep your corporate assets and finances separate from your personal ones.
b. Corporate structure also offers protections from liability to directors and officers so long as they honor their basic obligations to the corporation.4 However, under certain circumstances these protections also can be breached by the courts and the individuals can be held responsible. These situations are complicated and beyond the scope of this chapter. Get a good tutorial from your lawyer on this important area when you incorporate.
2. The incorporation process organizes founders and owners, defines ownership stakes, and clarifies boundaries that indicate who among the early-stage participants are in the company and who are not. At the formation stage, there are often people who think they should be owners when they shouldn’t, and sometimes vice versa. Almost always, interpretations will vary as to who is going to get what ownership in the company at some future stage. Incorporating can’t eliminate potential future claims, but generally incorporation codifies ownership. Although not necessarily making everyone happy, the process of incorporating brings most founders’ claims to the surface and makes their resolution clear to all.
3. The corporate structure is a principal means of defining governance: how the corporation will make decisions and function effectively. Some forms (corporations) have statutory requirements to provide for a minimum of governance structure, such as shareholder meetings, boards, and officers. Others are more flexible and allow owners to create their own governance and management structures (limited partnerships and limited liability companies [LLCs]). In corporations, boards make almost all decisions. (An important exception is the sale of shares in an acquisition.5) In LLCs you can specify how decisions are made. You may want to require specifically in the corporate bylaws a supermajority vote of directors or even shareholders for certain important decisions, such as funding events, mergers or sales, changes in the bylaws, and the taking on of new partners. In all cases, the structure of the corporate entity clarifies how decisions are made, how roles are defined, and how the entity operates.
4. Most often, start-ups will need significant funding sooner or later. Investors generally want to invest only in companies, not persons or partnerships, and they generally have strong preferences for a particular form (see below).
5. Incorporating limits lender claims, keeping your personal assets free of burdens.
6. There are certain tax considerations in forming a corporate entity, some favorable and some not (more below).
There is a trade-off on the timing of when to incorporate a start-up enterprise. Waiting too long can lead to all sorts of loose ends that need cleaning up and often many misunderstandings and conflicting expectations on the part of founders (see point 2 in the list above). However, incorporating too soon, while the founding dynamics are still fluid and evolving, means you’ll probably have to make major changes later. That can get expensive and time-consuming, and can create potential tax complications.
When people put effort and resources into an enterprise over a sustained period, what they expect to get back escalates. At some point, those expectations can grow to the point where it is difficult to meet them all. When you are approaching that point is not always obvious, but even when things pass that point, often people don’t notice because they aren’t paying attention. Incorporating gets all this out in the open and deals with it. Usually there is some external trigger, such as the need to enter a business arrangement or close a financing, that creates a need for a corporate entity.
The choice of a form of entity is fundamental and important, but there are some options that leave you with the flexibility to choose provisionally now and change to another form later without a lot of cost or hassle. There are two dimensions to the question of choice of entity, and it’s important not to confuse them.
One is how to think about the choice: What are the important questions that should drive the decision? The other is: What options do you have for an entity? Too many people jump immediately to thinking about the options for form of entity, neglecting to consider the important drivers or questions that should inform their choice, the factors that should be important to them. Here are some examples:
Are you planning a for-profit company or a nonprofit?
Reporting and administrative obligations vary. How much structure do you need taking into account the burdens that go with it? Burdens can be expensive.
What are your personal tax considerations? Do you want to have income and losses from the company consolidate to your personal return (flow-through entities) or be isolated in the corporation and subject to double taxation?
What might be important to your investors? Generally, all but the earliest-stage investors don’t like flow-through entities such as Subchapter S corporations and LLCs.
The options among forms of entity are thoroughly treated in many resources, and most attorneys have a briefing brochure on incorporation options. Selected features of corporate forms are summarized in Table 13-1.
Note: If you are thinking about creating a nonprofit corporation, remember that the 501(c)(3) designation is a tax status, not a form of corporation. Nonprofits will be treated in detail in the next chapter.
First, unless you are considering a sole proprietorship, don’t attempt to do this by yourself. Even a sole-owner corporation or LLC has filing, state law, and tax requirements that can trip you up. Attorneys will have a checklist of decisions needed once you jointly agree on the right entity and the state in which to incorporate. You will need a name that passes a “confusingly similar” conflict test; check with the secretary of state in the state where you are filing. In addition, you will look carefully to see that there are not company names on which you might be infringing in other states, as trademarks are often an issue. Among the documents you and your attorney will create are the following:
Initial incorporating documents (articles or certificate of incorporation); certificate of formation (LLC). The attorney creates these.
Corporate bylaws (corporation); operating agreement (LLC). These will require many decisions on the terms in the bylaws, including composition of the board, creation of officer positions, and any decisions for which you want approval to require more than a simple majority vote of directors or shareholders (such as major financing decisions, sale of major assets or the company, major transactions such as mergers and partnerships, and changes in the bylaws).
Stock subscription or purchase agreements. Decisions include the price of shares, vesting, restrictions on selling shares, and provisions on potential sales (right of first refusal, right to participate in a sale, or drag other parties along in a sale).
Initial corporate actions, including issuance of shares and price, and authorization of officers to conduct different business and finance functions.
Election of officers and directors.
Employment or “key-person” agreements, including any confidentiality and noncompete provisions needed.
Subchapter S election forms (IRS 2553) if you decide to do a Subchapter S flowthrough.
Employer identification number application (IRS Form SS–4). You will need this to open a bank account.
Table 13-1 Selected Features of Corporate Forms*, †, ‡
Letters of intent (sometimes called term sheets, memoranda of understanding, or heads-of-agreement) are a mechanism to force clarity and resolution of vague issues, memorialize verbal intentions, and protect against changes in conditions—or changes in someone’s mind. Properly done, a letter of intent is not a binding legal agreement. Letters of intent clarify and memorialize in writing key terms in a transaction or negotiation. They play an invaluable role in negotiations by forcing parties to be methodical and systematic about covering key issues. Positions are clarified by putting them in writing. This is one of the more important things you as leaders in an organization can do, both for your companies and for your attorneys. Attorneys can create binding documents much more efficiently when working from a letter of intent that has the business issues worked out. Usually you will draft them without active involvement of your lawyers. Trying to have attorneys get involved from the start and negotiate all the business and legal issues at the same time not only complicates things but generally ends up taking longer to reach agreement on the business issues and sometimes makes it impossible. Also, both parties are paying for all that extra legal time to do things they probably can do more effectively on their own. Use letters of intent to get things done efficiently and use your attorneys for what they do best: craft good agreements.
Letters of intent should not be binding agreements, only outlines of important deal provisions resolved in principle between the parties. In fact, they should lack the form of legal agreements. When done correctly, they are drafted specifically and explicitly to be nonbinding. Failing to make this clear in the document leaves a risk that in the event of a breakdown, one party may try to enforce a carelessly drafted letter of intent. Drafted poorly, such letters can have some of the elements of a binding agreement even though they are not complete and specific enough that parties’ interests are fairly covered. This is the worst of both worlds: a vague agreement that courts feel is binding but in which many of the terms are unclear. The best advice: Open the document with a clear statement that what follows is a “non-binding recital of terms and understandings discussed with respect to the subject transaction.” Never use the word agree or agreement in the document. We prefer to write letters of intent as “memorializing what the parties discussed,” containing “understandings that will later be negotiated as part of binding agreements.”
In light of the care taken to avoid appearing to bind the parties, it’s fair to ask what value there can be in a letter of intent. In most cases, parties understand there is a moral commitment to honor terms resolved at this stage. It’s a bad sign when someone fails to honor terms previously memorialized in a term sheet without a reasonable change in conditions. You may want to reconsider proceeding with a party too quickly to try to change terms previously resolved. Here are some of the important issues that normally turn up in a letter of intent:
1. Form of transaction (terms): a list of alternatives if there are more than one
2. Important transaction elements: what each party will give and get
3. Expectations management
a. Responsibilities of all parties
b. Timeline
4. Key considerations
a. Confidentiality?
b. Exclusivity?
5. Process going forward
a. How will decisions be made?
b. What kind of agreements will be needed?
c. Who will be involved?
d. Authority lines of the parties?
6. Next steps
A contract is a legally enforceable agreement or commitment. A contract need not be in writing: In certain circumstances courts will recognize oral and even implied agreements. Courts can hold that promises made in some circumstances are implied contracts that are legally enforceable, especially in areas involving employment. This is why it is so important to memorialize negotiations in good notes and nonbinding letters of intent and to follow that with properly drawn contracts. For a contract to be enforceable there must be four elements:6
1. There must be an agreement between the parties involving an offer and an acceptance.
2. There must be consideration: Something of value must be exchanged between the parties.
3. The parties must have the capacity to enter into a contract (mentally competent and of legal age).
4. There must be a legal purpose.
Many agreements are written in the form of contracts:
Employment agreements and noncompetition/nonsolicitation agreements
Stock-purchase agreements
Consulting or independent contractor agreements
Sales contracts or licenses
Distributor agreements
Purchase and sale agreements on real property
Lease or rental agreements
Confidentiality agreements
For an early-stage enterprise, an important agreement is the confidentiality agreement, also called a confidential disclosure agreement (CDA) or nondisclosure agreement (NDA). These are contracts between at least two parties that define confidential information the parties will disclose but wish to hold confidential from other parties. Usually employee, consulting, and independent contractor agreements will contain confidentiality language. Confidentiality agreements must do the following:
Have the statutory elements of a binding contract to be enforceable.
Contain a promise by the receiver of information to do the following:
Avoid unauthorized use or disclosure—use only as intended.
Limit use and disclosure to parties identified in the agreement or obtain written permission to disclose.
Exercise appropriate care in preventing disclosure by others.
Describe what information is protected. It’s a good practice to create a schedule or exhibit, mark all documents as confidential, and number and label them.
Include preservation of intellectual property rights, current and future.
Include a reasonable term and expiration.
Avoid ambiguity (e.g., verbal representations).
If you are going to be the recipient of a disclosure and are being asked to sign a confidentiality agreement, remember that you are binding yourself to protect confidentiality and exposing yourself to claims of damage if you breach the provisions. Parties have been sued for damages even when they didn’t feel they breached an agreement. Be aware that you are incurring a potential future liability whenever you commit to protecting confidentiality under such an agreement.
Be sure the agreement is limited to a reasonable time; anything beyond two to three years is unreasonable in most normal circumstances. Look for areas of knowledge or technologies that are defined too broadly or vaguely. Also, watch for non-competition, nonsolicitation, or assignment of ownership of inventions language. These can slip into confidentiality agreements. They may be appropriate to the circumstances, but that should be for you to decide. Especially when lawyers draft agreements for their clients, the practice is to ask for everything conceivable and then negotiate on the assumption that the other side is going to do the same thing.
There is ample further reading on the details of all these contracts in several good books, such as The Entrepreneur’s Guide to Business Law,7 among many others. When you see a transaction or situation arising that probably will end in such a contract, do your homework in advance. Look them up, and if necessary talk with your lawyer so that you understand the main factors and potential pitfalls in advance. Otherwise you may find you have to do cleanup work when it comes time to draft a contract.
In the end contracts are not a substitute for consensus, good intentions, continued alignment of interests and benefits; a guarantee there won’t be disputes in the future; or magic. Contracts can’t fix things you negotiated poorly and can’t turn bad behavior in your counterparty into good behavior. You want the best, most enforceable contracts your lawyer dollars can buy, but you can never rely exclusively on the existence of a contract to make everything go right. Unfortunately, at the core, a contract is only a license to sue. Good agreements can keep you out of a lot of trouble but can’t save you from poor intentions or people gone bad. The first line of defense is always the character of the people you deal with. Choose wisely.
The second line of defense is being realistic and diligent in the negotiation and contracting phases, thinking ahead about what might go wrong in the future. Look for areas where problems could develop and deal with them early. Wishful thinking and willful disregard of problem signs have been the cause of much subsequent misery. Never rely on future litigation as your defense against potential problems you foresee. Litigation is sometimes a resort of necessity, but it’s never wise to think of it as a resort of choice. Get things right the first time, document them thoroughly in agreements, and don’t leave items lingering that can cause problems later (“no skeletons in the closet”).
Yogi Berra supposedly said, “It’s hard to make predictions, especially about the future.” (The physicist Niels Bohr and others also may have said it.) Since things don’t always happen in the future the way we anticipate, agreements sometimes don’t work out as hoped even when it’s no one’s fault. Of course, sad to say, sometimes we misjudge counterparties and sometimes people change their minds and don’t live up to terms of agreements. When this happens, there are only so many options: live with it, dispute it, or see if amendments can leave parties reasonably satisfied. Who can change the terms of a signed agreement? The parties to an agreement can make changes at any time by mutual written consent. Sometimes this is the best way to avoid having things spiral out of control.
Then there is the ever-present possibility that litigation will come to you unbidden, not related to contract disputes. Sometimes you may have created this opportunity for an enterprising member of the tort bar. Unfortunately, today sometimes it’s a result of creative claiming. In any case, if you operate in business long enough, in today’s climate you probably will have to confront disputes or claims that have the potential to land you in court. Count the costs before initiating litigation, but of course you have to be prepared to defend your interests if someone initiates a claim against you that you think is without merit. Don’t reach that decision casually or without coldly calculating the costs going forward, taking care to ignore sunk costs you can never get back. Usually, people drastically underestimate litigation costs in time as well as fees. Unless you’re the litigating attorney, litigation is saldom a good way to make money even if you think you’re pursuing a valuable entitlement. Judgments are hard to collect. However, if you decide you have to litigate, do it with thoroughness and intensity.
There are a number of increasingly popular alternatives for dispute resolution, including negotiation, mediation, and arbitration. Often in contracts parties will commit in advance to submit contract disputes to arbitration and designate one of the major arbitration bodies for referral. Even without such a clause, it’s always wise to see if both parties can agree to go to arbitration with a dispute. Sadly, in the absence of a prior commitment, often there is an advantage to one party in using the threat of costly and time-consuming litigation as a lever in settlement negotiations. Consider including an alternative dispute commitment in contracts.
Hiring people immediately puts you into the world of employment law, one of the most complex areas of business law. There is a bewildering array of legislation and regulation—state and federal—regulating the conduct of business with respect to employing people. For example, there are the antidiscrimination laws: the Civil Rights Act of 1866 (Section 1981), the Equal Pay Act of 1963, Title VII of the 1964 Civil Rights Act, the 1967 Age Discrimination in Employment Act, the Vietnam Era Readjustment Assistance Acts (1972, 1974), the Vocational Rehabilitation Act (1973), the Veterans Reemployment Act (974), the Immigration Reform and Control Act (1986), the Americans with Disabilities Act (1990), and the Civil Rights Act of 1991, along with tort cases on discrimination and harassment. There are the Family and Medical Leave Act of 1993, the Fair Labor Standards Act (1938) that regulates minimum wages and overtime pay, the Occupational Safety and Health Act’s regulations and inspections, the Employee Retirement Income Security Act, and the National Labor Relations Act. And that is only at the federal level!.
Then there are all the things employees are entitled to receive by statute and regulation: FICA and Medicare contributions, worker’s compensation insurance, unemployment compensation, severance (in some states), vacation pay, medical plan coverage, and so on. Most of these elements can be avoided by contracting with people as independent contractors. This is an alternative for a company at any stage, though the larger the company, the greater some of the practical disadvantages, including high turnover and loss of control. For early-stage companies, hiring people as independent contractors is a common practice. Often this is how all the first people are hired. Flexibility and the absence of legal burdens are both important.
There is a critical downside to be aware of: Courts and the Internal Revenue Service (IRS) can retrospectively deem someone to be an employee even if you and the contractor agree the arrangement is independent. For example, by IRS regulations and various employment statutes, to claim independent status, there must be agreement on the work product, but the contractor must control the means and manner of achieving the outcome, and the contractor’s services must be on offer to the public at large, not just to one business.8 In addition, there are numerous factors and criteria the courts have used to deem a relationship an employment rather than an independent contract. Written contracts are always useful but provide no guarantee that you will sustain an independent classification. Before embarking on your first arrangements, do your reading9 and get a tutorial from your attorney. If you plan to do enough work with independent contractors, get from your attorney a template and checklist of documentation and administrative practices. Getting this wrong can be costly and time-consuming.
There are any number of specialties not just in employment law but in narrower areas within it. You cannot possibly have all the knowledge needed to cover everything, but someone in your company should be responsible for understanding enough to institute good practices, policies, and procedures. This is something you will have to grow into—one reason why starting up is usually more fun than building out. In the early days, once you confront your first hiring decisions, you should at least get from your attorney a good checklist of the most important employment law issues to cover and get right the first time. Soon you will find that good office administrators more than pay for themselves with the experience and knowledge they bring. Unless you are one of those administrators, your time and skills are better spent building the business.
You have seen how there are risks in contracts that go bad and in mistakes about employment law. With those, your company’s exposure to liability is just beginning. You face product liability claims, investor claims, torts for negligence related to your business, citations for pollution and environmental damage, employee claims for discrimination or harassment, violations related to recruiting employees from companies at which you or others in your company may have worked, violations of noncompetition or confidentiality agreements, anticompetitive behavior, interfering business practices, domestic and foreign corrupt practices, and fraudulent conduct. That’s only a partial list, but it’s more than enough to highlight the importance of thinking about preventive medicine.
The first line of defense against liability, of course, is good policies and practices designed to prevent problems from being created in the first place. In the event of litigation, an important factor that courts consider is the degree to which you have good policies and practices in place to prevent problems. In theory at least, they also help prevent problems. This is one more area for at least an overview education and a prioritized checklist from your attorney. You can’t focus on your business and worry about everything at the same time, but everything can be a worry. That’s why it takes judgment, not just procedures.
The second line of defense is good insurance. Today you can insure against almost anything except fraud and intentional misconduct. Insurance is one of those things you can easily overbuy, but once you have assets and a business to protect, going without is a nearly certain disaster sooner or later. Your resource for dealing with all this is a good business insurance agent. To get an agent, you can find a good broker who shops among companies and assembles packages for you or you can deal directly with an insurance company representative. There is no right answer, but generally if you are not experienced, brokers can be more valuable because of the experience and breadth of company products they bring. How do you choose one? It’s about the same as finding a good lawyer: referrals and comparative shopping.
At a minimum, in the early days you probably will have to bind at least minimum directors’ and officers’ liability coverage, worker’s compensation insurance, general liability, and product liability. If you are doing anything that could damage or pollute the environment, such as biotech, chemical work, or manufacturing, you will need environmental coverage, which is expensive. Your broker can go through a checklist of potential products and coverages. In addition to policy costs, pay attention to deductibles, caps, and coverage exclusions.
To protect investors, the Securities Act of 1933 established the Securities and Exchange Commission (SEC). The act requires people raising money from the public to register their offerings with the SEC and provide investors with a prospectus containing specified information about the offering and the issuer.10 Such registered offerings are expensive and time-consuming. Fortunately for startups and small companies, there are exemptions to the SEC rules for certain kinds of private offerings under Section 3(a)(11) (intrastate offering exemption) and Section 4(2) (transactions by an issuer not involving a public offering). Less fortunately, the conditions to qualify for the SEC exemptions can be complicated, and there are numerous state laws that are relevant as well.
Regulation D11 of the SEC defines the requirements to claim a safe harbor12 exemption from registration. The regulation exempts offerings to accredited investors and provides a detailed definition in Section 501. If you plan to raise money, be familiar with this definition and document that your prospective investors meet the criteria. Most attorneys provide a short questionnaire for your investors to complete and sign. Keep them on file. There are three exemption categories of concern: Rules 504 (offerings up to $1 million), 505 (up to $5 million), and 506 (any amount offered to no more than 35 accredited investors). There are requirements for what information must be provided, certain procedures, and filing with the SEC on the first sale of securities.
There is an exemption for sales of securities through employee benefit plans. Rule 701 states that sales of up to $1 million of securities made to compensate employees of companies do not need to be subject to Securities Exchange Act reporting requirements. Regulation A allows for a simplified registration for U.S. and Canadian companies wanting to go public with offerings of $5,000,000 or less, $1,500,000 in certain circumstances. The SEC has a good resource section on small companies and securities regulation at http://www.sec.gov/info/smallbus/qasbsec.htm.
Section 3(a)(11) provides certain exemptions for intrastate financings. All the U.S. states, the District of Columbia, and Puerto Rico have securities laws that regulate the offer and sale of securities by companies headquartered there or those offering securities to investors in their jurisdiction. Many of the states, Washington, D.C., and Puerto Rico have adopted a common code, the Uniform Securities Act, but some others, including California, still have their own statutes. The California Limited Offering Exemption—Rule 1001 provides an exemption for offers and sales of securities, in amounts of up to $5 million, that satisfy the conditions of §25102(n) of the California Corporations Code. This exempts offerings made by California companies to qualified purchasers whose characteristics are similar to those of accredited investors under Regulation D and allows some methods of general solicitation before sales. The Uniform Securities Act emphasizes disclosure for protecting investors, but some state securities administrators have the authority to deny permits unless there is a finding in a merit review that the plan of business and the proposed issuance of securities are fair, just, and equitable.13 Certain of these provisions are overridden by the Capital Markets Efficiency Act of 1996 in the case of offerings exempt under Rule 506 of the SEC’s Regulation D. Sounds complicated? Call your lawyer!
No one starts out expecting a company to take on financial obligations and debts and then go broke, but it happens. In that event, the first stage consists of attempts to arrange suitable workouts that, if not pleasant (an understatement), at least let a company continue to operate and often emerge from the problems successfully. If that does not happen, foreclosures and bankruptcy follow.
If you have started your business as a corporation or LLC and have maintained accepted practices of separating your personal business from the corporation, you are not financially at risk for the company’s obligations beyond any investments, guarantees, or other pledges you previously committed to the company. If you are operating as a sole proprietorship or partnership, your personal assets can be at risk.
Starting up is not the time to invest a lot of effort in understanding the nuances and strategies in workouts, foreclosure, and bankruptcy. Still, you will be entering into all sorts of financial obligations going both ways: what you will owe others and what others will owe you. There are a number of places where you can slip up and regret it in the future if you don’t have a working knowledge of some of the important factors in insolvency management. For example, priority of claims in bankruptcy should be a factor when you accept obligations from others: Where will you stand in terms of recovery if the company that owes you goes under? What kind of terms do you want to receive or offer in security agreements? How will you be able to juggle the claims various lenders and vendors will want to place on you when you are arranging financing and borrowing terms? How will you protect the security interests you hold in other companies or assets? What kinds of guarantees (especially personal guarantees) are wise to make and which kinds are not? Bagley and Dauchy’s Entrepreneur’s Guide to Business Law has an excellent chapter on creditors’ rights and bankruptcy.
Whether you know it or not, from the first actions you take to incorporate and begin doing business you are making decisions that will have serious financial consequences. If you don’t realize it then, you will when it comes time to pay taxes. Few things can be more painful than finding out too late that there were ways to save a lot of money on taxes. Tax evasion is illegal; tax avoidance is your right. Think about it early.
Like almost everything else discussed in this chapter, taxation is a thicket of specialties and subspecialties, and there are federal, state, and even local levels to deal with. If you make money through net income or sale of your business, taxes will be one of the larger financial issues, and the amounts can be substantial. Prior planning—and anticipation of future opportunities and problems—can go a long way toward making those amounts as painless as possible. Think about the following:
Choice of entity and flow-through on taxation:
LLC and Subchapter S corporations flow earnings and losses through to the owners. Streaming of early losses can be valuable to some owners or investors. Note that there are restrictions on the deductibility of losses under passive loss rules.
Some owners may want to deduct losses and don’t need current income, and vice versa. Note that Subchapter S limits the ability to stream losses and income disproportionately. LCCs have this flexibility.
Make sure that you don’t set yourself up for phantom income from flow-throughs. Early-stage companies often generate net income but choose to retain the cash in the company to fund future growth. This can create timing issues that result in income flowing through to owners that is recognized for tax purposes and not realized in cash. In other words, the owners have to report income and find cash from somewhere else to pay the taxes on the reported income.
C corporations pay their own income taxes, and any distributions of earnings (dividends) or proceeds of sales are taxed again at the individual level. This seems punitive, but most small companies have low net incomes; they reinvest revenues for growth, and so there aren’t meaningful cash dividends anyway. In addition, within limits, some earnings can be streamed to certain owners as compensation without being taxed at the corporate level. Therefore, as a practical matter, most small companies actually pay lower tax rates on their earnings than they would if the earnings were streamed back to individual owners.
Note that if you plan to sell assets of a corporation early, before raising significant money, flow-through entities avoid having proceeds of the sale taxed twice.
How will you set up for capital gains tax treatment on sale of assets or the company? Pay attention to basis and holding periods.
How will you issue shares and options to founders and employees?
Watch for valuation issues. There are extensive IRS rules on this practice. Issuing shares at prices that reflect less than current valuations can result in a tax liability to the recipient; this is another instance of recognizing income without realizing the cash to pay the taxes. See in particular the rules around Section 409A, which governs deferrals and distributions of nonqualified deferred compensation paid by a service recipient to a service provider. Compliance is complicated; there are many gray areas, especially involving valuation questions, and penalties are stiff. Deferred amounts for the current year and all previous years can become immediately taxable, plus a 20 percent penalty. This is a job for outside expertise.14
For tax purposes, restricted shares (vesting) can be treated as owned on grant rather than when vested. This has important tax implications, particularly in terms of setting up to receive capital gains treatment on an eventual sale. To be eligible for this treatment, you must file an 83b election with the IRS within 30 days of the grant of shares, and there are no grace periods on the filing. This one bites many a founder and occasionally even the lawyers.
Options plans have a number of taxation elements that require special attention. You should never draft one on your own, and the attorney doing it for you should be knowledgeable about tax considerations. Options granted at prices below current valuation also can trigger the “recognized and not realized” problem.
You must set up to process and pay payroll taxes correctly. The IRS is vigilant about payroll tax accounting and prompt payment. Shortchanging the IRS on payroll taxes can be expensive and painful.
Income tax planning. There is no greater tragedy than having a start-up find early sales success, only to discover that no one has planned ahead on matching expenses and income, leaving the company to pay precious growth capital to the IRS in income taxes. Pay attention in advance to what’s deductible and the timing of expenses. Don’t pay taxes earlier than you should.
Set up for sales tax accounting early.
There are often numerous franchise taxes in your state of registration as well as state income taxes and any number of miscellaneous state and local taxes. Your accountant and attorney are your first lines of defense to be sure you pay everything you are required to pay, but realistically, there’s no guarantee any one person is going to know them all.
Paul Sweeney, Esq., is a partner and deputy chair of the business department at the law firm Foley Hoag LLP, focusing on venture capital financings, mergers and acquisitions, strategic alliances, and related business transactions. Paul provides legal advice to entrepreneurs regarding corporate formation issues, contract negotiations, equity distribution and compensation matters, venture capital and debt financings, mergers and acquisitions, reorganizations, strategic investments, and joint ventures and other partnering transactions. Paul also represents venture capital investors such as Polaris Venture Partners and Highland Capital Partners in connection with their portfolio investments.
I work with entrepreneurs and their investors every day. Legal mistakes I see early entrepreneurs commonly make fall into three categories: mistakes in forming the company, issuing equity, and protecting intellectual property.
Mistakes in Forming the Company
You can wait too long to form a company. It is sometimes unclear exactly when to incorporate, and some entrepreneurs push this off given the perceived costs involved. Before you have something of value or are dealing with third parties such as cofounders, investors, customers, suppliers, and employees, you should have your company incorporated and do all your transactions in it.
Problems often arise when an entrepreneur chooses an unnecessarily complex legal structure. Often this means creating a limited liability company when a simple C or S corporation will do. LLCs are sometimes appropriate, but often their advantages (“pass-through” taxation treatment) are never exploited, and their disadvantages (greater complexity, higher cost to create and maintain) hamper the company in its critical early stages.
Mistakes in Allocating Equity
Allocating equity is always a challenge, as is dividing the pie without being divisive. Often failing to face hard choices early leads to big troubles later.
Legal troubles arise when companies are too casual in the early days about tracking who owns what. Keep accurate and updated records of equity ownership and other rights. Unresolved questions on capital structure can scare away investors and potential acquirers and result in unintended dilution to the founders.
Promising cofounders or other recruits a percentage of the company rather than a specified number of shares can create confusion or animosity; worse, it can imply that the percentage of equity is immune from subsequent dilution.
Mistakes in Protecting Valuable Intellectual Property
Failing to establish strong intellectual property rights and aggressively protect them can extinguish big value in a company overnight.
Sharing confidential information without protection cannot be rectified once it happens. Disclose your ideas and inventions cautiously and gradually and be aware that even unintentional disclosure might preclude patentability or limit trade secret protection. Anyone handling confidential information should be covered by a nondisclosure agreement: employees, contractors, and outsiders alike.
Everyone who creates intellectual property on behalf of your company should be bound by an assignment of inventions agreement with the company.
We hope we have covered most of the major worries that will appear on your worry list, though as we often tell our companies, hope is not a plan. In light of all the ways legal issues can affect your business and trip you up, there’s no sure way to know that you have everything covered or even that your specialists will. In the end, your best defense against troubles is a broad understanding of the important issues, a good team, constant vigilance for issues of concern, and lots of ounces of prevention so that you won’t have to worry about cures later.
How will you decide on the balance between spending precious cash on legal matters and spending on other start-up needs, especially in the early days?
How will you educate yourself about what matters are important enough to worry about? If your lawyer is like many, he or she will feel most matters are important because they are all potential risks.
How might you minimize the effort and cost of dealing with legal risks in the early days, anticipating that you will do more as you grow and have more assets at risk?
1. Bagley, Constance, and Craig Dauchy, The Entrepreneur’s Guide to Business Law (Mason, OH: West, 2008).
2. Miller, Roger Leroy, and Gaylord A. Jentz. Business Law Today: The Essential. (Mason, OH: South-Western-CENGAGE Learning, 2011).
3. See the section on term sheets and memoranda of understanding below for details on how to do these things correctly. It’s important that their form be nonbinding.
4. These obligations are listed in Chapter 9.
5. See Chapter 22.
6. Bagley and Dauchy, 2008: 182–187.
7. Ibid.
8. Ibid.: 268.
9. See, for example, ibid.: 267–271.
10. Ibid.: 157.
11. For an explanation of Regulation D, see http://www.sec.gov/answers/regd.htm (accessed October 10, 2010).
12. A safe harbor provision in a statute or regulations limits liability to penalties if certain conditions are met or defined actions or policies are in good faith.
13. Bagley and Dauchy, 2008: 165–169.
14. See http://www.irs.gov/irb/2007-19_IRB/ar07.html and http://www.irs.gov/newsroom/article/0,,id=172883,00.html (accessed October 10, 2010).