So, you’re ready to turn your idea into a business. You have the business plan and generally know the path forward, except you aren’t entirely sure what legal matters you should address. Here is an overview of a handful of initial matters you likely will want to consider:
Should I form an entity? Yes, assuming your business – like most businesses – will interact with anyone other than yourself. An entity enables you to have co-owners, receive investment capital, employ others, grow the value of your business, and if you observe certain formalities, an entity may help protect your personal assets from your business liabilities.
Which type of entity? This decision will depend on some knowns and some guesses about the future of your business, including your financing plans, who your co-owners and investors are likely to be, the employees you’ll hire, and tax considerations, among other factors. That said, of the many entity types, the most common forms for startups are the limited liability company (LLC) and the corporation.
The LLC provides significant flexibility for ownership and management structuring as well as favorable “pass-through taxation” (i.e., the company does not pay tax on its income; only the owners do), however, the LLC is subject to potentially complex partnership tax rules and may subject owners to self-employment tax rules.
As to the corporation, there are two distinct types: the “S-corporation” or “C-corporation.” The primary difference is that the S-corporation benefits from pass-through taxation (similar to the LLC), whereas the C-corporation itself pays tax on its income, and then, if it distributes the post-tax cash to its owners, the owners also pay income tax (so-called “double taxation”). So, why wouldn’t everyone choose the S-corporation over the C-corporation? Although both the S-corporation and C-corporation have the same governance structure, the S-corporation has strict limitations on who the owners can be (i.e., mostly individuals, a few trusts, but no other entities, such as Venture Capital (VC) funds or the like) and it may only have one class of stock (i.e., it cannot have preferred stock and common stock, often required by certain investors). In contrast, the C-corporation has no such limitations on who the owners are or the equity capital structure, and virtually all public companies are C-corporations and many traditional VC funds can only invest in a C-corporations.
Choosing a name. Regardless of which entity you select, you’ll need a company name. You should carefully search whether your proposed name is available for use by your company. There is nothing more frustrating (and potentially costly) than having to change your company name after investing several months (or years!) and resources into the name. And, whether or not your company name will be the same as the trademark for your product or service mark for your service (frequently it is), you may also want to conduct a trademark clearance search; check out the Intellectual Property (IP) section for more info.
The formation process. First, you need to complete the appropriate entity formation document and file the document with the Secretary of State’s office in the state your entity is formed. Second, most entities will need to obtain a Tax I.D. Number from the IRS. Third, if you choose a corporation, the corporation must adopt bylaws. Fourth, if you choose an S-corporation, you must timely make an “S Election” with the IRS. Finally, you must register your company in any state in which your company is “doing business,” which is a definition applied on a state-by-state basis.
Owners’ agreement. If your company has more than one owner, you likely should prepare a shareholders agreement (corporation) or an operating agreement (LLC) to be signed by all of the owners. These agreements recite the terms that are binding on all of the owners regarding business purpose, management, voting, financial and tax matters, ownership transfers, and other key terms. It’s always best to establish the “rules of engagement” when everyone is cooperating and there are no disagreements.
In addition to entity formation, other “starter” items to consider are:
Business registrations/licenses. Depending on your business, you may need to obtain specific business or tax registrations or licenses from applicable governmental authorities.
Non-disclosure agreement (NDA). Have an NDA ready, so that everyone with whom you share your business information is required to keep it confidential and not use it.
Asset ownership. Make sure your company actually has title to or license to use all of its intended business assets and rights (e.g., inventions, ideas, other IP, real or tangible property, etc.) – this “chain of title” is accomplished via assignments or contribution agreements.
Formalities. Take basic measures to demonstrate that your company is its own, separate entity, including by electing a board of directors (or comparable governing body), appointing officers or other authorized agents, opening a bank account in the company’s name, obtaining insurance (as appropriate), ensuring contracts are in the company’s name, and observing the various other formalities applicable to the company’s entity type.
One day your business will make more money than it spends, or at least that’s the goal! Until then, you’ll need capital. If you’re able to (and desire to) fund your company yourself, great, you can skip this section. But, if you’re like most startups, you need money from others, below are a few pointers as you navigate the funding landscape:
“NO DILUTION” please! Many founders know they need money, but understandably want to avoid diluting their ownership or ceding control of their baby. But, if your idea cannot be taken to market without capital, then investors may be essential. In other words, owning 60% of a valuable company is almost always better than owning 100% of company worth zero because it never got off the ground!
What type of funding is available? Like anything, there is a “market” for money. You are competing with many others for investors’ money. Most investors have their own “rules” regarding investments they can or cannot make – for example, they may have investment criteria regarding industry or sector, the management team, the maturity of the company, whether they’ll invest via debt or equity, the terms required for each investment, etc. An investor will evaluate not only the specifics of the opportunity you present to the investor (such as the product-market fit, management team, business plan, risks, and possible returns), but also how your specific opportunity measures against the many other opportunities presented to the investor.
What are the different forms of investment? Generally speaking, an investment will be made either in the form of “debt” or “equity,” although with the advent of “crowdfunding,” a donation alternative also may exist. Briefly, these options are:
- Debt. Debt involves a lender providing you a loan that must be repaid on a fixed “maturity” date and you must pay interest on the borrowed amount. Very often debt is only available to more mature companies that can demonstrate the ability to repay the loan.
- Equity. Equity means the investor becomes a co-owner of your company by contributing money or property to your company in exchange for a share of the equity in your company. Although your ownership stake will be diluted, normally there won’t be a fixed obligation to repay the amount invested.
- Donation. The earliest form of “crowdfunding” (e.g., Kickstarter, Indiegogo) was a donation-based platform, akin to a non-profit, where persons donate money to you in exchange for an award, but have no expectation of repayment. As noted below, crowdfunding has now expanded beyond the donative format.
Let's take a closer look at these alternatives.
Debt. It’s possible you already have debt – a credit card is debt, albeit very expensive debt (e.g., 18-20% interest rate). Business loans are provided by banks and other non-bank lenders. Any lender will evaluate your creditworthiness and the likelihood it will be repaid, which, in turn, leads the lender to determine, initially, whether it will make a loan to your company and, if so, on what terms (e.g., interest rate, maturity date, repayment schedule, covenants and restrictions, and security interests). Most often, the lender only receives repayment of the principal plus the interest, but doesn’t receive unlimited upside if your company’s value soars. Since lenders often don’t share in the upside, most traditional lenders won’t make high-risk loans; thus, many startups don’t qualify for a traditional bank loan, whereas more mature businesses with a consistent earnings history do. Startups may have a better chance obtaining loans backed by the government (SBA), from non-traditional lenders, peer lenders (e.g., Prosper.com) or others. In any event, with debt, you likely won’t suffer dilution to your ownership stake, but you’ll have a fixed obligation recorded on your balance sheet, which must be paid on a fixed date and which may be secured by a lien on your assets, all of which may hamper your business growth and other plans.
But, wait, I’ve heard many startups use “convertible debt”; what’s that? You’re right, convertible debt is an investment instrument often used by startups and their investors. Convertible debt normally is used when an investor desires to invest in the company’s equity, but the parties cannot currently agree on the company’s valuation and your business plan calls for an equity financing in the near future, at which time a company valuation will be established and at which time the debt may be converted into equity. Sometimes the debt converts automatically and sometimes it converts only at the election of the investor. To induce the investor to invest now and await later determination of the equity stake the investor actually will receive, the debt usually will accrue interest and will convert into the equity issued in the next equity financing at a discounted price. So, while convertible debt can be a useful tool for the startup, like other debt, the company will have debt on its balance sheet and will owe interest to the investor. At the same time, the investor takes some risk that the loan ultimately converts into less equity than had the original investment been in your company’s equity.
Equity. Most often, a startup will raise money by selling equity – that is, actual ownership in your company. This means your ownership position is diluted and you will now have other owners to answer to. Terms of equity investments can vary wildly depending on many factors, including when in the company’s lifecycle the equity is issued, who the investors are (e.g., friends & family, angel or “seed” stage, venture capital, etc.), and other market factors and forces. We’ll only touch on a few common themes across various equity financings:
Valuation. An equity financing requires that you and the investors agree on the value of your company before the investment (“pre-money” valuation) and how much money will be invested (“investment amount”). The pre-money valuation plus the investment amount equals the “post-money” valuation of your company, and generally speaking, the investor’s equity percentage normally equals the investment amount divided by the post-money valuation. For example, if your company’s pre-money valuation is $2,000,000, and investors invest $500,000, the post-money valuation will be $2,500,000 and the investors will receive 20% of your company’s equity (i.e., a $500,000 piece of the $2,500,000 pie). The real challenge is determining the pre-money valuation, and with startups, it’s often far more art than science, since you don’t have revenue, earnings, customers, or perfect comparables.
Types of equity. In an S-corporation, all of the equity must be the same class of stock. But, with an LLC or C-corporation, you can issue equity with different rights and preferences. Often, if you are raising money from friends and family, everyone might have the same class of equity. In contrast, if you are raising money from a venture capital firm or angel, they may require that they have a “preferred” equity and you and the other preexisting owners/founders, will have a “common” equity. Just like it sounds, preferred equity tends to have a few preferences or enhanced rights over the common equity, including but not limited to the following:
- A dividend that may be payable each year or, more likely, accumulates and is paid in connection with a sale transaction, Initial Public Offering (IPO) or other event;
- A “liquidation preference” whereby the holder of preferred equity receive certain proceeds (e.g., original capital plus cumulated dividends) upon the occurrence of certain events, such as a liquidation or a sale of the company, before the holders of common equity receive any proceeds; and
- Special voting or management rights (discussed below).
Voting & control. Along with the amount of equity the investor will receive, you’ll need to address whether the investor will simply be an owner with the basic rights afforded an owner under law, or whether the investor will have additional rights, such as a right to designate a member of the Board of Directors (or other governing body), special voting or veto rights, certain special information rights, etc. The former is more commonly associated with friends and family rounds, whereas the latter is more common in a VC financing.
Ownership restrictions. When you have multiple owners, you’ll want to agree on if/when each owner may sell their ownership stake, whether other owners will have the “right of first refusal” to buy the shares, if/when all owners may be required to sell their shares to a buyer of the company (“drag along rights”), and various other rights and restrictions on any transfer of ownership.
Securities laws. While your need for money is very clear, what, when, and how laws apply to raising money may not be as intuitive. Generally, these “securities laws” will apply anytime you take money from investors who are not also actively involved in working for the company with you and those investors expect money back at some point. Securities laws are complex, and you will need to carefully analyze applicable laws and regulations before embarking on any fundraising effort, but here are a few considerations:
- Most of the time, you can only seek money from someone you already know well (family or friend). If you want to expand your pool of potential investors, you will be restricted in the way you identify and contact such additional investors, how you describe the investment opportunity, and who helps in this effort. In short, with limited exceptions, you can’t blast your offering materials out publicly, on the web, etc., and you can’t pay just anyone to facilitate your fundraising.
- The amount of money you seek to raise, who your prospective investors are, and where your investors are located will dictate which laws and regulations will apply.
- You may be required to provide certain minimum information to your investors before they invest. Regardless of what information you are required to provide or do provide, just remember certain laws protect investors from material misrepresentations or omissions in the course of your fundraising.
- Critically, if you don’t follow the rules carefully, you could unwittingly be required to register your fundraising as if you are conducting an IPO, which can cost millions of dollars and would subject you to burdensome regulations!
The key is to understand the laws before you embark on the process!
Oh, by the way, what is “crowdfunding?” Originally, crowdfunding referred only to awards-based platforms (e.g., Kickstarter, Indiegogo), whereby participants donate money to your company in exchange for pre-determined “awards”; participants don’t receive a financial return on their donation, so governmental authorities have viewed these platforms as not being subject to securities laws. In contrast, Congress and various states have adopted new securities laws that permit startups to raise money from “crowd” in the form of debt or equity. This newer form of crowdfunding is subject to securities laws, but with various modifications to the traditional rules. As of July 2015, crowdfunding is still not permissible nationwide under federal law; however, crowdfunding may be available within the boundaries of a handful of states.
Ok, you have your idea, money, and a plan. Now, or soon, you need to add a critical ingredient – a team of people – to make it all happen. Adding “human resources” triggers many legal considerations, and here are a handful of tips to consider:
The hiring process. Initially, employees may be friends or family, but they also may be former colleagues or strangers. Regardless, you should adopt standard operating procedures for engaging all human resources. Everyone is happy now, but misunderstandings, false expectations, or bad memories can quickly erode relationships and value. So, remember these three basic steps:
Background. Determine if you desire to, or are legally required to, conduct background checks, proof of the right to work in the US, or other pre-employment checks…and, of course, make sure the background checks are conducted legally and are properly documented!
Offer letter. Use a written offer letter (that the employee countersigns) that sets the basic employment terms: “at will” employment (i.e., either party can terminate employment at any time and for any or no reason), the employee’s role, wages and benefits, any other agreements (e.g., NDA/IP Assignment) the employee must sign, any policies with which the employee must comply, and confirmation that the employee is not restricted from working with you due to any restrictive covenants with former employers.
NDA/IP Assignment. Every employee should sign an NDA/IP Assignment, by which the employee confirms that he or she is not bringing third parties’ IP to the company, agrees to keep business information confidential and not use it other than for your business purposes, agrees IP and other work product produced for the business or on business time/equipment are owned exclusively by your company, and agrees to notify future employers of these restrictions. Failure to do so may result in your company not owning its IP or being able to protect its critical information and assets.
Employee or contractor? You may have been told it would be simpler and cheaper to make each person an “independent contractor.” Unfortunately, the classification is not purely elective; rather, federal and states laws generally apply multi-factor tests, which, while a touch foggy, dictate whether a service provider is an employee (in which case you must withhold income taxes, pay payroll taxes, and report wages on a W-2 ) or an independent contractor (no withholdings, no payroll taxes, report on a 1099). Take the time to get this right, as misclassification can result in potential exposure for back wages, premiums, penalties, attorneys’ fees, and getting stuck for a worker’s compensation bill without insurance, any of which can result in a far greater cost than the savings you originally envisioned. See real world examples in FedEx and Uber!!
Compensation: cash v. equity? You’ve also heard that you could just pay your new employees in equity, thereby preserving your scarce cash. CAUTION: Federal laws (and some states’ laws) require companies to pay minimum wages and overtime to employees, except for a select few “exempt” employees. Thus, if your employees are not exempt, you must pay minimum wages and overtime, and deciding to pay employees in equity does not modify these strict requirements. CAUTION PART II: You may be tempted to have employees defer the receipt of their cash compensation to some future date. Be careful! In addition to minimum wage and overtime problems, if such deferral is done incorrectly, you may violate deferred compensation rules (Section 409A) under the tax code, subjecting your employees to a 20% additional income tax (on top of their regular tax rates) on the deferred cash that they haven’t received. If you provide equity, be sure to remember:
Type of equity. Though other variations exist, the primary equity incentive awards for corporations are either a grant of shares of stock or options to acquire stock, and the primary equity incentive awards for LLCs are so-called “profits interests.”
Equity plan and reserved equity amounts. Most equity is provided through an equity incentive plan. There are a number of reasons for this, but in general, using an equity plan allows you to set aside a total number of shares (or LLC interests) that can be issued under equity awards both currently and in the future, and also allows you to provide a uniform set of ground rules for the types of awards that can be issued and the general terms and conditions of those awards. So, how much of the company should you reserve for issuance under the plan? Unfortunately, there’s no hard and fast rule here, as every company has a different perspective on compensation and issuance of equity as incentives.
Tax considerations. There are a host of tax considerations with any form of equity grant, but three key considerations for equity compensation for corporations are:
- If you grant stock, the employee is deemed to receive compensation equal to the value of the shares at the time the shares “vest” (i.e., when the shares cannot be forfeited or repurchased below fair market value), so your company and employee will have tax reporting, withholding, and payment obligations at such time;
- If you grant options, in nearly every instance, the exercise price must be at or above fair market value of the underlying shares at the time of grant; and
- If you grant so-called “incentive stock options,” which are prescribed under the internal revenue code, you’ll need to obtain certain shareholder approval. With respect to LLCs, profits interests generally provide the recipient only with a share of the LLC’s future profits and appreciation of the LLC (i.e., the recipient doesn’t receive a share of the LLC’s current value). The primary benefit of a qualifying profits interests is that the recipient is not subject to income tax upon receipt of the profits interests.
Vesting. Regardless of the form of equity, you may want the employee to earn the equity only after the employee has stayed with the company for a designated period of time or after the employee has achieved certain performance goals. If so, you should consider a time or performance “vesting schedule” that aligns with such objectives.
Buy back. What happens when an employee is terminated or resigns? Do they continue as an owner of your company? You should consider whether a company will have the right to buy the equity back from the former employee and on what terms.
Employee handbook. Do you need one? It’s highly recommended from the outset. If resources are constrained early-on, this may be one item that could fall lower on the list; however, if you wait, you’re more likely to be exposed to costly and time-consuming claims. For instance, a company should have a written policy prohibiting illegal harassment and discrimination and setting forth a reporting procedure for improper workplace behavior. Other important subject matters include proper use of company equipment and systems (including the company’s right to monitor activity), leaves of absence and absenteeism, and confirmation of at-will employment.
Employee benefits. You’re just getting your company off the ground and likely are too small to have your own medical insurance plan, so you decide to simply reimburse folks for their individual health insurance coverage. No problem, right? Wrong! Doing so can violate the Affordable Health Care Act and can subject your company to pretty steep penalties. Employee benefits are filled with traps for the unwary, so as you bring on employees, you’ll need to carefully consider what, if any, benefits you must provide or desire to provide. Naturally benefit plans can make your company more appealing to employees, but they can also be a strain on already constrained cash resources.
Other restrictions. You may be inclined to require employees to agree to non-compete and non-solicitation covenants. The enforceability of such covenants is highly dependent on which state’s laws apply, who the employee is, what roles and duties the employee has, whether you’ve specially trained the employee, the reasonableness of your restrictions (geography, timeframe, etc.), among other factors, so you should carefully review the applicable laws and possibly consult with legal counsel before drafting and using such restrictive covenants.
Self-employed? An odd result, but once an employee of an LLC also becomes an owner of an LLC, that person becomes “self-employed” for tax purposes, which fundamentally changes tax reporting and payments, which may come as a surprise. It may be possible to create more complex entity structures to address this issue.
Interns. Another purported employment cost-saver is labeling a person an “intern.” As with the employee/contractor determination, applicable laws define when a service provider qualifies as an intern, and it may be more limited than is obvious. Thus, you should first review and understand the current legal requirements for who may qualify as an intern before bestowing such title on a service provider.
For some, the identity and value of their intellectual property is obvious. For others, it’s not as clear. Either way, you should be aware of the basic contours of the “IP landscape," so you can identify IP, develop an IP strategy, and maximize the value of your IP. Here’s a brief overview:
Confidentiality. Information and ideas are core to your business. The value of your business and its advantages over competitors may depend on you possessing your special information and ideas, while your competitors don’t. Thus, you should have all employees, contractors, and any other person or entity that may receive your ideas or information sign a proper NDA before receiving access to such information. Keep in mind, there really isn’t a “form NDA” – the NDA needs to be customized based on the relevant circumstances surrounding the disclosure.
Strategic decision: keep it secret v. make it public? Although not every idea is patentable, when you have an invention that may be patentable, you will need to carefully and critically decide whether you seek patent protection (which means you’ll disclose your invention publicly in exchange for the potential issuance of a patent covering your invention) or keep your invention private by employing careful confidentiality practices.
Patents. Simply put, if you have an invention that meets the various criteria for a patent, and the US Patent & Trademark Office (USPTO) issues you a patent, then you receive the right to prevent others from practicing the technology covered by your patent for a period of time. This can be a highly valuable asset, but you should be aware of some of the burdens and costs inherent in the patent process and with patent ownership. There are strict deadlines for filing patent applications, so this protection is not available to everyone who has a valuable invention. Filing and prosecuting a patent application can take years and it can be expensive. Applications are scrutinized carefully by the USPTO and are not granted routinely. If your patent application is unsuccessful, you will not benefit from patent protection, and meanwhile, all the details of your invention are irreversibly exposed for all to see. If you are successful in obtaining a patent, to truly prevent others from practicing the invention covered by your patent, you’ll have to enforce your patent in a legal proceeding, which can be extremely expensive.
Trade secrets. Some, but not all, categories of information may qualify as “trade secrets,” but only if you use reasonable efforts to maintain the confidentiality of such information; again highlighting the importance of having an NDA in place prior to sharing any such information. You may also need to employ other safeguards over your information for such information to qualify as a trade secret. If you properly comply with all of the requirements, then you’ll benefit from additional legal remedies if someone misappropriates your trade secrets.
Copyrights. If you record an original creative expression into a tangible medium – paper, video, audio, electronic form, sculpture, etc., and such creation consists of subject matter protected by copyright laws – you automatically have a copyright and are afforded copyright protection. But, if you want to gain enhanced rights, such as being able to seek statutory damages and recover attorneys' fees if you sue an infringer, you can apply to register your copyright with the US Copyright Office.
Everything is NOT “work made for hire.” You’ve likely heard someone say that you’ll automatically own all IP rights to work product produced by your employees and contractors as a “work made for hire.” CAUTION: this is a myth. A “work made for hire” applies only to copyrights (not other IP rights, such as patent rights). While all copyrights created by employees within the scope of their employment will belong to the employer as a work made for hire, copyrights created by contractors are treated very differently. Only defined, limited types of work products created by your contractors can be designated as a work made for hire, and only if your company and the contractor have agreed in writing to designate such eligible copyrighted work product as a “work for hire.” Thus, any time you expect to own any work product and related IP, you should have a written IP Assignment with the service provider performing the work.
Your brand. Any symbol, logo, name, slogan, or other mark that identifies the source of a product or service is referred to as a “trademark” for products or a “service mark” for services, as applicable. For many businesses, the mark may be its most valuable IP; for others, it may have limited value. In any event, as you evaluate potential marks, you should be mindful of a few considerations. First, you need to be sure you aren’t infringing on others’ marks – generally the standard for infringement is whether there is a “likelihood of confusion” among the relevant public between your mark and another company’s mark. Second, a mark is more valuable and more likely registrable with the USPTO, the more fanciful or arbitrary the mark is; conversely, a trademark is less valuable and is less likely to be registered, the more descriptive (of the good or service) the mark is. For example, Zillow is fanciful or arbitrary (i.e., the word doesn’t describe real estate services), making it a stronger mark, whereas Rocky Mountain Lumber is more descriptive for of its underlying logging services located in the Rockies, making it a weaker mark. There certainly are other “no no’s” in this territory, such as piggy-backing on a well-known brand or celebrity’s name, so you’ll want to take care in adopting your mark.
Your trade name or d/b/a. You already have your official entity name, and very often that’s enough. But, you may desire to conduct your businesses under an alias (sometimes referred to as a “d/b/a”), in such case, you must file such alias as a “trade name” in the states where you filed your entity formation document and qualifications to do business. Your d/b/a will be subject to the same availability criteria as your official entity name.
Domain name & social media. As you are creating your name and your brand, you should evaluate whether your name or brand is available as a domain name, as a Twitter or Instagram handle, or any other relevant social media application. Once you settle on your name and brand, it is advisable to obtain these other properties concurrent with obtaining name registrations, trademark registrations, and the like.
Day-to-day management of your company will be driven largely by business drivers and market forces, rather than legal matters. Nevertheless, here is a laundry list of common issues your company may encounter or may consider addressing along the way:
Corporate “good housekeeping.” As mentioned in “Start,” you should have a board of directors (or other governing body) and owner meetings as required by law and your entity documents, and you should record minutes of those meetings. Your board should carefully review and approve matters prescribed by law for board approval. Note that such review and decisions are subject to a host of so-called “fiduciary duties.”
Contracts. Throughout the course of your company’s life, it will enter many contracts. Often when receiving goods or services from others, you’ll be asked to sign their contracts, but when you are selling your product or service, you likely will want your own form of contract. The purpose of contracts is to clearly explain the parties’ intentions and to allocate commitments, responsibilities, and risks between the parties. So, be sure you clearly understand, in advance, exactly what you are signing. While startups often have less negotiating leverage than their counterparties, you should still negotiate business and legal terms that are critical to your business and long term value and viability.
Accounting & financials. Basic, day-to-day accounting and financial management can consume lots of time and can rapidly grow in complexity. Thus, whether you do-it-yourself or outsource it, it’s important to clearly define and understand your processes.
Taxes & reporting. Local, regional, state, and federal taxes may apply to your company or your business. You should clearly investigate and understand your registration, collection, withholding, payment, and reporting obligations before you commence operations.
Risk management & insurance. Initially, you may not perceive many risks, as your business doesn’t interact with the outside world. But, before you know it, it very likely will. Thus, it’s preferable to engage in risk management analysis as early as possible, including, determining what internal policies you should implement and monitor and what insurance policies your company should procure and maintain.
If things go wrong? Naturally you’re embarking on a new venture because you’re an optimist or otherwise wholeheartedly believe that your business will succeed. Experience, unfortunately, tells us that things don’t always go as planned and can turn into costly litigation (time and money). Litigation often results from poorly drafted documents (or lack of documentation), so when drafting your documents, review them from a perspective of how a third party would interpret the documents if something goes wrong.
While some entrepreneurs start companies with no intention of ever selling their business, many will start a company with the aim of one day selling their company or taking it public – the so-called “exit event.” Whether or not you currently plan on an eventual exit event, and whether that day is near or into the distant future, you may find these few tips helpful:
Timing. Your business plan may anticipate the precise time of your exit event. However, as is more frequently the case, it can be hard predict when the “right time” to sell will be. Very often circumstances within and outside your control combine to define the right time to sell, including your business success, growth and value, the debt and equity markets, the unique factors and forces driving potential buyers of your business, etc.
Types of exit events. The exit event can take several different forms, based on a host of factors. These factors include, among others, your entity type, characteristics of your ownership and whether you want to sell 100% of your company or want to retain some ownership, your company’s assets and tax characteristics, who your buyer is, debt and equity markets, company liabilities, and the terms of your licenses, registrations, and contracts. In short, it’s impossible to predict what type of exit event you’ll ultimately undertake, but it is clear that you can optimize your exit event – valuation and structure – by being mindful of an exit event along the way, from forming and organizing your company, to managing your business, to basic organization of business records, to how ordinary course business decisions are made, among various other actions.
Process. Even the process for your exit event can vary markedly, but generally speaking, most processes follow a similar path, such as:
Finding the buyer. A suitor may approach you out of the blue or you may approach a likely prospective acquirer, and your match is made. More commonly, you are unsure who your buyer might be or how to reach and engage prospective buyers. In that case, you likely would want to engage an investment banker or other third party that can assist you in “telling your company’s story,” help set your expectations on the value of your company, identify probable buyers, contact such potential buyers, and help negotiate and structure the transaction.
Due diligence. Invariably, once you have selected the buyer or offering pathway, you should be prepared for extensive “due diligence” on your company, including business, market, and operational reviews, accounting, financial and earnings investigations and audits, legal diligence, and other evaluations of your business.
Term sheet. Sometimes before or during due diligence, you and the buyer will negotiate an outline of the material terms of your deal – this is usually memorialized in a letter of intent or term sheet. Most of the letter of intent will be legally non-binding, however, a few terms usually will form a legally binding contract, such as requiring you to exclusively deal with the buyer (and no other possible suitors) for a fixed period of time and requiring the buyer to keep your information confidential.
Negotiations. As the buyer feels sufficiently comfortable with its due diligence results, the parties will negotiate the various “definitive agreements” for the transaction.
Closing conditions & closing. Finally, you will proceed to “closing” the transaction, which is the time when ownership and money or other consideration changes hands. Leading up to the closing, there may be a handful of obligations that must be completed (e.g., a landlord’s consent is required) before the parties are required to consummate the transaction.
Key deal points. Again, there are too many flavors of transactions to describe the many deal points you may be asked to negotiate, but here are key points that are customarily addressed:
Purchase price & form of consideration. Invariably you and the buyer will agree on the “purchase price” for your company. Sometimes that will be a fixed price. Other times, the purchase price will be partially fixed and partially contingent on certain factors, such as future performance of the business. In addition, very often you will receive the purchase price in cash, but you may also receive a promissory note from the buyer, equity in the buyer’s entity, or other property.
Payment terms. Most sellers will want most, if not all, of the consideration at closing, as the sellers are handing over their company at closing. With that said, some deferred payments are common, such as a portion of the purchase price being made by issuance of a promissory note, and/or a portion of the purchase price being placed into “escrow” as security for certain post-closing obligations, and/or a portion of the purchase price being paid as an “earn out” based on your company’s financial performance following closing.
Risk allocation. Your transaction likely will have a series of “risk allocation” terms, including factual representations and warranties you will make to the buyer about your company and business, and indemnification obligations you will undertake in the event your representations and warranties are not accurate (or certain liabilities are otherwise identified) and such inaccuracy or liabilities result in damages incurred by the buyer. Such indemnification normally will be taken from the escrow or otherwise will require you to reimburse the buyer in some fashion.
Other covenants. Transactions may have a whole host of covenants, but common covenants include confidentiality obligations, non-compete covenants, certain tax payment and reporting obligations, transition services obligations, and other post-closing covenants.