Post Category → Formation

Why experienced entrepreneurs hire better lawyers.

There are goods and services for which quality is apparent to the consumer from the beginning, and then there are those where what you actually got for your money can take years to figure out.  Transactional lawyering is decidedly in the latter category, although it often takes a client some personal seasoning (or good advice) to figure that out.

Fundamentally, there are two “jobs” that a client will typically hire outside corporate counsel for in a transaction. The first is getting the transaction done. This is the job that all clients are aware of, no matter how much experience is under their belt.  As long as the client gets his/her desired economic terms, papers get signed, and wires get initiated, all seems to have gone as planned.

But the more experienced entrepreneurs (and unfortunately that experience often isn’t pleasant) know that good legal counsel will serve a second function. While not as simple to define as the first, let’s call it transactional insurance. Some illustrations would be helpful here.

Formation. You have a great startup idea, got together with some co-founders, and want to make it official. You incorporate, issue some founder stock, perhaps authorize an equity plan, and you’re good to go. Put the papers away and forget about them. No worries here, right?

  • What if one of the founders later claims that some of the Company’s IP is his/hers and not the Company’s?
  • What if some of that founder’s work was done on a prior employer’s time/hardware, and that employer now claims ownership of the IP?
  • What if one of the founders dies? Where does their stock go?
  • What if one of the founders gets divorced. Where does their stock go?
  • What if a founder decides to leave the Company after  a year? Where does their stock go?
  • What if someone sues the Company and you personally?
  • What if the IRS comes back 4 years from now and says you owe them a bunch of $ on your vested stock?
  • What if it turns out that a founder had a non-compete agreement with a prior employer with deep pockets, and working at your Company violates it?
  • Insert 3 dozen other scenarios here.

VC/Angel Financing: Everyone signed the papers and sent you checks. Awesome. No worries, right?

  • What happens if we decide to sell the Company early?
  • What happens if we want to raise a new financing, but not all of our current investors are on board?
  • What if an investor decides 5 years from now that he wants his money back?
  • What happens if the IRS claims 3 years from now that we issued stock at too cheap of a price and tax is owed?
  • What happens if an angel investor sues the Company claiming that we fraudulently withheld information from them?
  • What happens if the SEC claims that we sold stock illegally to unqualified investors? Wait, what does college football have to do with this?
  • Insert 3 dozen other scenarios here as well.

The quality of the process and legal drafting that took place in the above scenarios will determine whether a resolution could be as simple as (i) pulling up a document, (ii) pointing to Section 2.3(a)(i), and (iii) getting back to work, or something that could destroy years of hard work in an instant.

From the perspective of a lean entrepreneur who just wants Minimum Viable Lawyering, signing some papers provided for free or a few hundred bucks felt like success.  But experienced entrepreneurs typically have a better sense of the nightmare they may be inheriting by going with the attorney or firm who claims to do the exact same thing as the “overpriced” guys, but at a substantial discount.

Granted, there is a lot to be said for Job #1, and there’s no shortage of movement in the legal industry toward getting the transaction done quickly and cost-effectively.  That topic is the subject of perhaps 80% of my blog posts.  But something is only truly cost-effective when it efficiently accomplishes all of the tasks that you hired it for – not when it provides the trappings of a job-well-done, but kicks any number of disasters down the road.  

I can’t tell you how much time we spend cleaning up the work of bad lawyers who looked, at the time, like a bargain. Experienced entrepreneurs hire efficient lawyers. Inexperienced entrepreneurs hire cheap ones.

The Founder’s Stock Issuance

There’s a lot of uninteresting formality that goes on in a startup’s corporate formation, most of which founders rightfully ignore because they have better things to worry about.  But there’s one document that pretty much every founder will make sure to ready carefully – or at least ask lots of questions about: the Founder’s Restricted Stock Purchase Agreement (or some variant of that name).  Here’s a quick outline that an entrepreneur might use to walk through the document:

General Themes: We (1) want to make sure the Company owns all IP; (2) want to incentivize the founder to stay with the Company and add value; and (3) if the founder leaves the Company or someone else gets ahold of the shares, we want to be able to get them back so no one who isn’t involved with the Company has voting power.

  • Number of shares and nominal price – Most of the time the stock is sold at par value, which will be a fraction of a cent.  Because the Company is at the very beginning stages and extremely risky, placing this miniscule value on the stock usually isn’t considered problematic.
  • IP Assignment – In exchange for the issuance of stock, the founder assigns all rights to the IP that he/she may have with respect to previous work.  Look for a very long definition of what constitutes Company IP.
  • Repurchase Right – This is where you’ll find the vesting schedule.  Nutshell: a mechanism to require the founder to earn the shares over time, and giving the Company the right to get the shares back if anyone leaves.  Explaining that in more detail would take too long for this post, so just click that link.  Unless a founder’s gone solo, there should be a vesting schedule in the document.  If not, fire your lawyer, or get one.  Also useful: Vesting Calculator.  You’ll also likely sign some form of Assignment that gives the Company the administrative ability to exercise this right.
  • Acceleration of Vesting – Upon certain events, usually termination of the founder, a Change in Control (think acquisition), or both, a certain percentage of the stock’s vesting is “accelerated.”
  • Miscellaneous Securities Law Reps – Lots of stuff thrown in by lawyers to ensure that the document doesn’t violate any securities laws.
  • Right of First Refusal – Basically, you can’t sell the shares to anyone without the Company first being able to buy them on the same terms.  Meant to keep shares from getting into the hands of strangers.
  • Divorce/Separation Repurchase Right – If you divorce or legally separate from your spouse, and such spouse happens to get ahold of some shares, the Company has the right to buy them back.
  • Death Repurchase Right – This is somewhat more optional and language varies, but still quite common.  If the founder happens to pass away, the Company has the ability to repurchase shares at fair market value to prevent them from being transferred to the founder’s heirs, devisees, etc.
  • Transfer Restrictions – General restriction that you can’t transfer the shares other than through a “Permitted Transfer” (or some variant of that term), which usually includes gratuitous transfers (not sales) to immediate family and affiliate entities, and requires consent of the Company.
  • Escrow of Shares – The Company (actually their attorneys) will hold on to the actual certificates of the shares and handle administrative matters related to them.  This helps the Company enforce the transfer restrictions and other covenants in the document, and for future diligence purposes it just makes it easier to have them in one central place.
  • 83(b) Election Language and Form – Here’s an explanation.  You have 30 days from the issuance of the shares. It keeps you from being taxed as your shares vest.  Do it, or you’ll be sorry.
  • Compensation Agreement/701 Language – In a nutshell, all share issuances need to qualify for a securities exemption in order to avoid having to “register” the shares, which is crazy expensive.  Rule 701 is one such exemption, and it requires that the shares be issued as compensation – in this case they’re being issued in exchange for IP and past service – not for an investment.
  • Spousal Acknowledgement – Your spouse acknowledges all of the restrictions in the agreements, agrees to be bound by them if he/she ever gains ownership of the shares, and gives you (founder) the right to act on his/her behalf with respect to shares.  This makes sure community property won’t muck up the ownership and that nobody has to ask your spouse for permission to vote the shares or do anything else with them.

Obviously, to make all of these provisions work together there will be lots of extra detail providing processes for exercise, waiver, notice, and explanations for how each provision interacts with the other.  The devil is definitely in the details, and, if you’re working with a reputable firm, this document will have been screened by specialists in tax law, employment law, IP, etc. to ensure that they pass legal muster.  A lone generalist with no outside input can be dangerous.

The rise of the LLC

In startup land, the C-Corp has reigned supreme for a number of reasons, but largely because venture capitalists usually won’t invest in anything but a C-corp.

Background: For a general overview of the benefits/costs of LLCs v. Corps, I usually forward this article to clients What Type of Entity Should I Form? And if you want a simple argument in favor of C-Corps, try Top Reasons to Choose a C-Corp.

All of the above articles provide very good analyses on the legal and tax nuances of the two entity types, but at the end of the day, the real push for someone to use the LLC form is very simple: a single layer of tax without the handcuffs that S-Corp status places on your equity structure. Corporations have two layers. And the real pull away from it is just as simple: VCs only invest in Corps.

In our practice group, we’ve definitely noticed an uptick in the number of entrepreneurs choosing to start as LLCs from the get-go, notwithstanding the fact that our standard start-up fixed-fee package (quite popular) doesn’t apply to LLCs.   This would suggest that something related to the push/pull factors has changed.

The logical explanation for this trend would be unsurprising to anyone who follows the funding environment in the startup ecosystem :

  • Starting & running a startup keeps getting cheaper
  • Bootstrapping is therefore possible for much longer
  • Angel investing has become hip, so more early-stage non-VC capital
  • Strategic investment in startups from established companies is also on the rise

In a nutshell, these trends allow startups to last for longer periods of time without having to raise money from venture capitalists.  Angels and strategic investors are generally not LLC-averse.

If you plan on raising VC money in 6 months after formation, then the tax benefits of an LLC are pretty much null, especially when you factor in the cost of conversion at funding.  But for a number of companies who can now expect to operate for years, generate revenue, and even turn a profit well before raising a traditional Series A (if ever), the cost-benefit analysis of LLC v. Corp has changed.

C-Corp is still king, as it still should be for most tech startups, but the LLC is increasingly gaining credibility as well.  In the legal field, repetition is the mother of efficiency.  As more LLCs are formed, standardized docs will emerge, and the gap in legal costs between forming an LLC v. a C-Corp will continue to shrink.