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.
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...
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.
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.
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.
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.