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Startup Law

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Startup Law

A Legal Guide for Entrepreneurs Working on a Startup Venture

Copyright © 2017 The Law Firm of Ekaterina Mouratova, PLLC. All rights reserved.

Shakespir Edition

Disclaimer

The Law Firm of Ekaterina Mouratova, PLLC is pleased to provide this book as a legal guide for individual entrepreneurs and startup companies. It is designed to educate business people about laws and regulations that may apply to different business scenarios and therefore prevent inadvertent mistakes.

This book provides a general overview of the legal issues that are applicable to the modern-day startups and should be taken into consideration when planning business activities. However, no part of this book is intended to be an exhaustive discussion of these topics or all possible aspects of the corporate and other laws. The application of statutes and regulations may vary greatly, depending on the specifics of each particular situation and locality. Therefore, this publication is not an alternative to sound legal advice from a competent attorney.

This book does not constitute legal advice, and no person should act or refrain from acting on the basis of any information contained herein without first seeking appropriate legal counsel or other professional advice on the particular facts, circumstances, and issues at hand. The Law Firm of Ekaterina Mouratova, PLLC and all contributing authors expressly disclaim all liability to any person with respect to the contents of this book and with respect to any act or failure to act made in reliance upon any whole or partial information contained herein. Transmission of the information in this book does not create or constitute an attorney-client relationship between The Law Firm of Ekaterina Mouratova, PLLC and any reader of such information. Likewise, this book is not intended to serve as advertising or solicitation.

About the Author

Ekaterina Mouratova is the founder of The Law Firm of Ekaterina Mouratova, PLLC. She focuses her practice on business and corporate law, securities regulations, intellectual property, immigration, and real estate transactions.

Ekaterina represents individuals and companies in a broad range of industries, including sales, services, manufacture, e-commerce, financial, entertainment and many others. She provides sophisticated assistance and advice to clients in all aspects of their business and legal climates, including organizational, managerial, contractual, employment, and regulatory issues.

Passionate about the law and very dedicated to her profession, Ekaterina is a frequent speaker at seminars and author of multiple publications on business law. She is an active member of the New York State Bar Association, the American Bar Association, and a pro bono attorney via the Neighborhood Entrepreneur Law Project of the New York City Bar Association, a professional community that provides low- and middle-income entrepreneurs with legal services in all business matters.

In 2014 Ms. Mouratova established an innovative Startup Law Center (www.nystartuplawcenter.com) with purpose to provide affordable and highly efficient legal services, education, and collaboration to startups and small businesses. Focused on the needs of 21st century companies, the Center assists entrepreneurs at all stages of their development, from the establishment of the ventures to management and exit strategies.

Ekaterina can be contacted via

email: [email protected]

tel.: (212) 203-2406

Skype: ekaterina.mouratova

Other books published by Ekaterina Mouratova, Esq.:

Business Law for Entrepreneurs. A Legal Guide to Doing Business in the United States.

The Complete Guide to the U.S. Immigration Law

Available on Shakespir.com

About The Law Firm of Ekaterina Mouratova, PLLC

The Law Firm of Ekaterina Mouratova, PLLC, headquartered in New York City, NY provides assistance in the following areas:

Business and Corporate

Intellectual Property

Real Estate

Immigration

[+ Securities Regulations+]

The Firm represents individuals and business entities throughout the United States and abroad. It has resources to handle even the most complex matters and render sophisticated solutions.

The Law Firm of Ekaterina Mouratova, PLLC provides all-inclusive services and actively uses its connections with other professionals to accommodate the varied needs of its clients. Whether advising multinational companies on cross-border transactions and joint ventures or assisting individual entrepreneurs with start-up matters, all services are performed in an efficient, result-oriented, expeditious, and personable manner.

The mission of the Firm is to help its clients achieve their goals and succeed, regardless of the changing circumstances.

The Law Firm of Ekaterina Mouratova, PLLC

222 Broadway, 19 floor

New York, NY10038

Tel: (212) 203-2406

Fax: (212) 279-9743

Email: [email protected]

www.mouratovalawfirm.com

 

[] Table of Contents

About the Author 3

About The Law Firm of Ekaterina Mouratova, PLLC 5

Table of Contents 7

Formation and structuring of the companies 15

_ 5 Top Things to Consider When Opening a New Business 15_

Available Forms of Business Entities 19

[_ Pros & cons of various business structures 20_]

Joint Ventures/Partnerships 27

Not-for-Profit Corporation 32

Benefit Corporations 33

When do I need to register a company? 35

What state should I incorporate in? 38

[_ What is a Certificate of Incorporation and Bylaws? 40_]

[_ How many shares should be authorized in the Certificate of Incorporation? 41_]

[_ What par value and no par value means? 43_]

Founders Stock and associated features 43

[_ Should founders pay for their stock in cash or contribute intellectual property? 44_]

[_ Should Founders Stock be subject to vesting? 45_]

[_ If vesting is imposed, what are the typical vesting terms? 46_]

What is an 83(b) election? 47

[_ What does Incorporator’s Organizational Action mean? 49_]

[_ What is Unanimous Written Consent of the Board in Lieu of Organizational Meeting? 50_]

[_ What documents are typically included in a company organizational package? 51_]

[_ Who are considered the owners of the company besides founders? 52_]

Conducting business in other states 53

Explore the decision-making process 54

[* Operating agreements, shareholder agreements, founders’ stock agreements 56*]

[_ What is Founders’ Equity Sharing Agreement? What terms should it contain? 56_]

[_ What is a shareholder agreement and what are the terms it must contain? 57_]

_ LLC Operating Agreement and the terms it should contain 59_

_ Possible Legal Issues with a Former Partner and How to Avoid Them 65_

[_ Hackathons – Possible Legal Issues & How to Avoid Them 70_]

Various business and professional license 73

[_ How to find out whether your business needs a license? 73_]

Regulatory Compliance 75

  • Employment and Independent Contractor Agreements 79*

Human Resources and Employment Law 79

[_ What terms and conditions an Offer of Employment letter should contain? 86_]

[_ What is an Employee Handbook and why do businesses need it? 88_]

Employees vs. Independent Contractors 89

_ Legal regulation for employers who use interns 93_

What Payroll Taxes Do Employers Pay? 95

[* Non-compete, non-disclosure, confidentiality, assignments of rights and interests 97*]

Non-compete agreements 97

Non-disclosure/confidentiality agreements 99

Assignment of rights and interests 102

  • Equity compensation development and implementation 104*

[_ What equity compensation is about? Its pros and cons 104_]

Available equity compensation structures 105

Key Issues of Stock Compensation 107

[_ What is Equity Incentive Compensation Plan? 108_]

[_ What is restricted stock and the most common restriction associated with it? 109_]

What is restricted stock option? 110

The difference between ISOs & NSOs 111

What are Restricted Stock Units? 113

Stock Appreciation Rights 113

Phantom stock 114

Tax Considerations for Equity Compensation 115

IRS Section 409A 117

IRS Section 83(b) 119

[_ What documents are included in the Equity Incentive Compensation package? 121_]

_ Sample Questionnaire for Equity Compensation Plan 122_

  • Sale and purchase transactions, leases, licenses and multiple other business contracts 125*

_ A List Contracts Most Businesses Must Have 125_

Selling Goods in the USA 129

_ Key Issues to Consider in Intellectual Property Licensing 135_

_ 10 Top Things to Pay Attention to in Commercial Real Estate Leases 140_

Buying Commercial Real Estate 144

[_ Puffery, advertisement or a legally-binding contract? 150_]

Banking in the United States 152

Buying and selling businesses 157

How to structure transaction? 157

Due Diligence 162

_ Sample Due Diligence Request List for a private company 162_

Antitrust Law 164

Liquidity and Exit strategies 164

Forward Contracts 165

Financing a business 167

Available Forms of Financing 167

Debt vs. Equity 168

_ Basics of securities regulations for private companies 169_

_ General Solicitation in Relation to Capital Raising 175_

[_ Who is “accredited investor”? 183_]

Blue Sky Laws 184

Some resources to check out 186

Angel and Venture capital financing 188

Angel Investors 188

[_ Venture investors – what they are looking for in a company? 189_]

How to select a venture capitalist? 191

Different types of stock 192

[_ What is preferred stock and why it is issued to the investors? 193_]

[_ What are the most common rights of the preferred stock? 194_]

Valuation Strategies 196

Sample venture capital term sheet 198

Are Series A term sheets binding? 208

Should a term sheets be confidential? 209

What is a no shop provision? 209

[_ What documents are included in Series A financing? 209_]

[_ What are the conditions to the closing of a Series A financing? 210_]

Worst seed round terms for startups 211

  • Lending to and borrowing from the company 214*

E-commerce and information technology 217

Internet Business 217

Electronic contracts 222

Advertising 223

All agreements related to online business 225

Development Agreement 225

Website hosting agreement 226

Privacy Policy 227

Terms of Use 229

End-user agreements 230

Click-wrap Agreements 231

Browse-wrap agreements 232

Online commercial ventures 234

Corporate governance and compliance 237

[_ Directors & Shareholders – their rights & responsibilities towards each other & the company 237_]

Indemnification, Exculpation and Insurance 241

Board relations in a startup 243

Shareholder Voting Agreements 245

_ Duties of the Shareholders in Close Corporations 246_

Direct v. Derivative Law Suits 247

[_ What Piercing Corporate Veil means and when it may occur? 249_]

Regulatory Compliance 251

Regulatory Compliance 251

Importing Goods to the USA 254

Selling Goods in the USA 267

Internet Business 273

Consumer Protection 278

Product Liability 281

Antitrust Law and Regulations 288

Environmental Protection 298

U.S. Capital Markets 303

U.S. Taxation 309

Deductible Business Expenses 318

_ Business and Employment Immigration to the United States 323_

[* M&A transactions – mergers, acquisitions, divestitures, spin-offs, joint ventures and other partnering agreements 332*]

Mergers 332

Acquisitions 334

Spin-offs 335

Joint Ventures 336

  • Trademark, copyright and other intellectual property registration, protection, licensing, buying and selling 343*

Types of Intellectual Property 343

IP Concerns for Businesses 344

How to secure your trademark 344

A questionnaire for trademark registration 346

How to protect you copyright 347

How to protect your business idea 351

Patents 353

Trade Secrets 354

_ Key issues to consider in intellectual property licensing 355_

[* Strategic counseling and day-to-day legal advise 360*]

_ A Legal Checklist for Starting a Business 360_

_ 10 most common mistakes entrepreneurs make 362_

Startup Company Checklist 363

Governance and Housekeeping 364

Capital Raising and Financing 365

Stockholder Relations 367

_ Employees, Independent Contractors and Service Providers 368_

Employee Benefits and Compensation 369

Intellectual Property and Technology 371

Acquiring Intellectual Property Rights 371

Software and IT Policies 372

_ Product Development, Advertising, Marketing and Sales 373_

_ Data Privacy, Internet and Social Media Issues 374_

Real Estate and Leasing Issues 374

Insurance Issues 375

_ Startup Companies Avoiding Key Legal Mistakes Checklist 375_

Most common business related lawsuits 376

How to Choose A Business Lawyer 381

CHAPTER 1

[] Formation and structuring of the companies

5 Top Things to Consider When Opening a New Business

Business Structure

People establish new business ventures being led by various objectives and goals. The efficiency of one business form or another depends on the nature of the business and its methods of transactions and operations. Nowadays anybody can conduct business activities using one of the following structures: Sole Proprietorship, General Partnership, Limited Partnership, Limited Liability Company, Corporation. In order to determine which business form will be the most efficient for their activities, the organizers should ask themselves:

Whether they will be the sole owners or they may enter into partnership relationships with others

How much flexibility they need in daily operations of the company

What voting and managerial rights they want to retain for themselves and grant to other partners

Whether there is a need to protect their personal assets from liability that may be incurred during the business operations

Whether they may need to raise substantial capital through sources other than their close contacts or bank loans

Taxation Issues

Employees vs. Independent Contractors

If you are going to hire somebody else except yourself to serve for your company, you should consider whether you need to get those services from employees or independent contractors. There are differences between their obligations to the company and your liability for their actions. For example, you must pay certain taxes on every employee you have, you have complete control over their work performance and conditions of employment and vicariously liable for their actions performed during the course of their employment. Employees owe uncompromised loyalty to the company. If you deal with independent contractors, on the other hand, you are not responsible for withholding their taxes or making the matching contributions to the IRS, you don’t exercise constant control over their methods of work and accordingly, carry less liability for their actions, your relationship are temporary in nature and your require their services on “as needed basis”. Independent contractors can perform the same job for several companies at the same time. Remember that as your employees so the independent contractors can bind the company to certain liabilities in case if they act as the agents of the company. So it is very important to execute a written agreement with each of them before you enter into the business relationships, which state in detail what they can and what they cannot do on behalf of the company.

Contracts

Having the right contracts in place ensures that the business is run smoothly, prevents arguments and misunderstandings, helps to enforce your rights, protects from excessive liability, and often prevents protracted and costly litigation. The main contracts that most businesses should have are:

#
p<>{color:#000;}. Shareholder Agreement, Membership or Partnership Agreement depending on the legal structure of your company

Employment or Independent Contractor Agreement

Confidentiality Agreement, which prevents other people involved in your business from disclosing and using business inner information for their private benefits

Service Agreement and/or Sale Agreement. These are the contracts with your vendors and customers which guide your relationships, set parties expectations and obligations

Intellectual Property Assignment Agreement or License, if you use the work product of other people in your business operations

Terms of Use for the Website. Under certain conditions advertisement and puffery may be considered an enforceable contract. So it is important to disclaim expressly to the users of your website what you intend to be responsible for and what they should discuss with you personally.

Commercial space and equipment

If you are not conducting your business from your apartment, most likely you will have to enter into a lease either for office, store, or storage space. You should consider how long you are willing to rent the space, the possibilities of lease extension and/or termination, the possibility of expansion in the future, renovation needs, personal guarantee or other terms required by the landlord, what collateral services are included in your lease agreement (for example, will you have access to the building after the business hours, the operation of the air-conditioning and heating system after the business hours, cleaning services, the option to use your own Internet and phone provider or only the one already present in the building, the existence of the parking space for you and your customers/clients and many others).

Concerning the necessary equipment, you may compare leasing vs. buying options. Then, in a lease or sale agreement you should pay close attention on guarantees, future price changes, return/exchange policy, etc. It is very important to have a business attorney review every agreement you enter into, as very often the fully executed contracts are enforceable in Court and you should know exactly your rights and liabilities before you commit to something.

Insurance and Business Planning

Life presents us with all kinds of situations. Instead of taking a wait-and-see approach and hoping for the best or worrying excessively, it is possible to protect yourself and your business in advance. Here come all kinds of insurance policies you may need or want to have – business liability insurance, worker’s compensation, auto insurance if you use a car for your business, property insurance in case of property damage (e.g. wind, flood, fire) or loss of valuable documents or products, business interruption insurance, medical and life insurance, to name just a few. The benefits of having a certain type of policy greatly depend on the expenses it helps you to save. Accordingly, when comparing different insurance contracts think about your needs for the coverage limit, deductibles, tail coverage/prior acts exclusion, etc. Dealing with different policies may be tiring and overwhelming at first, but once everything is in place, you can concentrate on developing your business knowing that you are protected from unexpected surprises.

Each of the above topics will be reviewed in greater details in the subsequent chapters.

Starting a new business enterprise is an exciting and rewarding experience. Although it may seem challenging at the beginning, American small business owners declare themselves to be much happier than their peers, according to a new survey from TD Bank, – “remarkable 69 percent of American small business owners polled for the TD Small Business Happiness Index would describe themselves as “very happy,” with 61 percent believing they are happier than their peers.” This research further revealed that nearly 9 in 10 American small business owners are happier owning and running their own business as compared with working for someone else.

Opportunity is missed by most people because it is dressed in overalls and looks like work.” Thomas A. Edison

Available Forms of Business Entities

The law gives certain flexibility to entrepreneurs in the structuring of companies. This choice between several legal forms of entities allows entrepreneurs to expedite the beginning of their commercial activities and obtain maximum productivity. Currently the following business structures exist:

sole proprietorship

general partnership

limited partnership

limited liability company

C corporation, and S corporation

Non-profit, and not-so-long ago developed new structure

B corporation

The efficiency of any of these structures depends on the nature of the business and the goals of its organizers. In order to determine which type of entity is the best for particular commercial activities, organizers should ask themselves:

#
p<>{color:#000;}. Will I be the sole owner of the company, or will I enter into partnership relationships with third parties later? How much flexibility do I require in daily operations of the company? What voting and managerial rights do I want to retain for myself, and what percentage of these can be granted to other partners?

Is there a need to protect my personal assets from liability that may be incurred during business operations?

Do I need to raise substantial capital through sources other than my close contacts or bank loans?

What form of tax and accounting system do I prefer?

Business organizers should carefully compare various legal structures in order to determine which one will be most beneficial for their business activities.

Pros & cons of various business structures

Below is a review of the basic characteristics of various legal forms of business enterprise.

Sole Proprietorship

In a sole proprietorship, business activities are not separate from other activities of the entrepreneur. This form is best suited for single-owner business that does not have tax concerns and for which potential product and/or service liabilities are minimal.

Pros:

The owner (proprietor) has sole control over the business.

It is simple and inexpensive to create and operate.

Income, deductions, and expenses are paid by the owner, who reports it on his or her personal income tax return. The company is disregarded as an entity for taxation purposes. Though in New York City and some other municipalities, an unincorporated business tax is imposed.

Cons:

There is no limit on personal liability for business activities. The creditors can go after the owner’s personal assets in order to satisfy debt.

Access to capital and other business resources is limited by owner’s assets or personal ability to get loans.

Business operations are wholly dependent upon the owner’s performance; this is risky, in that illness or other factors may impede the owner from working.

General Partnership

A general partnership is not separate from its owners, and the partners are personally liable for the debts of the business. It is best suited for multiple owners, all of whom will manage the company, and potential product and/or service liabilities are minimal for their type of business.

Pros

It is simple and inexpensive to create and operate.

The company does not pay taxes. Income, deductions, and credits pass through to the partners in the portions set forth in a Partnership Agreement, and they pay applicable taxes. Bear in mind that New York City and some other municipalities impose an unincorporated business tax on partnerships that operate within their borders.

Cons

Partners are personally liable for business debts and lawsuits. Most importantly, each partner is also personally liable for the actions of other partners. In other words, if the liable partner does not have enough assets to cover damages, creditors can go after the personal assets of other partners in order to satisfy debt that is incurred during the business activities of their partnership.

It is difficult to remove and/or change partners without dissolving the partnership unless otherwise specified in a formal agreement. The entire business venture dissolves upon separation of a single partner, unless otherwise initially agreed upon. Therefore, it may be difficult to deal with an uncooperative partner; he or she will have much leverage, knowing that business continuity depends on his or her participation.

Limited Partnership

A limited partnership has two or more owners; at least one is a general partner and another is a limited partner. The company exists as a separate legal entity from its owners. It is best suited for two or more owners, when one seeks a passive investment with no interest in day-to-day management of the company.

Pros

Partners can claim losses and business expenses as personal tax deductions. The taxes are reported and paid by each partner separately. In New York City and some other municipalities, partnerships are subject to an unincorporated business tax.

Liability of a limited partner can be limited to the extent of his investment. He or she only stands to lose the amount invested in the company, and personal assets are not vulnerable.

Limited partners do not participate in company management.

Cons

General partners are personally liable for business debts and lawsuits, and this includes the actions of other partners. Creditors can go after personal assets of each general partner.

It is difficult to remove general partners without dissolving the partnership unless otherwise initially agreed upon and formally documented. Accordingly, partners depend on each other’s cooperation.

Limited Liability Company

A limited liability company is a separate legal entity from its owners. It is best suited for single or multiple owners who seek protection from unlimited liability and single-level taxation.

Pros

Liability is limited to the extent of owner’s investment; personal assets are protected.

Profits and losses may be allocated differently than owners’ contributions, upon agreement between them.

Capital can be raised through the sale of company interest.

The entity does not pay taxes separately from its members. The income, deductions, and credits are applied to the members in portions set forth in an LLC Agreement, and they report it on their personal income tax returns; however, members are taxed on allocations, not distributions of the profits, so they will owe taxes even if they decide to reinvest the profits rather than take it for themselves. One exception is the unincorporated business tax imposed by some municipalities (such as New York City) when an LLC has more than one owner.

LLC owners have a choice regarding taxation; they can choose to be taxed as a corporation if it is more beneficial in their particular situations.

Cons

It can be difficult to raise capital. The sale of membership interests in an LLC can create concerns or challenges for investors, as not everyone is interested in becoming an official LLC member.

Corporation

Corporation owners are referred to as shareholders. The corporate entity can have an unlimited number of shareholders; thus, this form is best suited for multiple-owner business seeking both limited liability and established procedures for management and funding.

Pros:

There is limited owner liability for business debts and lawsuits. Owners may only be personally liable in certain situations when their activities can be proven to be egregious.

Capital can be raised through the sale of stock rather than through bank assistance or personal loans.

Lawsuits are brought against the corporation rather than against the owners or managers of the company. The payment for liabilities is limited by the company assets.

There are tax-deductible fringe benefits, including health insurance and retirement plans.

Cons:

There are many administrative formalities in managing the company (mandatory regular shareholders and directors meetings, documentation of every major decision and maintenance of records, etc.).

Shareholders are exposed to double-taxation. When a corporation earns income, it pays taxes on the earnings as an entity. After that, if a corporation distributes dividends to its shareholders, the shareholders are taxed again on that dividend income. Shareholders first pay taxes on the overall profit as a company, then secondarily pay taxes on individual share of profit. Double-taxation may be mitigated by expenses and losses. Also, corporate income may be distributed in form of compensation rather than dividends, but this may be done only to the shareholders, who are simultaneously employees of the company.

S Corporation

Generally, an S corporation is a closely-held company, a good choice for small or family businesses that seek to avoid the double-taxation imposed on a corporate entity, while preserving limited liability and established procedures for business operations and funding.

Pros:

The S corporation offers all advantages of a regular corporation.

In addition, there is only one level of taxation. The company does not pay taxes on income, and only shareholders pay taxes. However, shareholders do owe taxes on business income even if the profits are not distributed (for example, reinvested in the business). This taxation form is similar to the taxation of LLC members, except that New York City does not recognize S corporation status for NYC tax purposes, so S corporations in NYC must pay entity-level city taxes if the business is located in New York City.

Cons:

The company may not have more than 100 shareholders and cannot publicly trade its shares.

Nonresident aliens (residents of other states) cannot be shareholders.

Generally, another corporation, an LLC, or a partnership cannot be a shareholder; only individuals can buy shares.

Administrative duties can be complex for small business owners. They have to go through extensive procedures in order to set up, operate, and dismantle the company.

This overview of various types of legal business enterprise structures should give you an understanding of the pros and cons for each, enabling you to decide what will work best for you and your business practices. To make an optimal decision regarding the form as well as applicable taxation, you should individually consult with a business attorney and discuss all features pertaining to these structures in greater detail.

Joint Ventures/Partnerships

Either individual entrepreneurs or business entities can form a partnership. It is important to notice that partnership can be formed explicitly by entering in the partnership agreement, which is certainly recommended way of doing business, or by default. When more than one person is operating a business without undergoing legal formalities, the law views such relationship as a general partnership and prescribes certain duties and liabilities to the partners by default. In other words, if two or more people run a business without taking the steps to incorporate, the law automatically views them as general partners. The legal test for determining if a partnership has been formed asks whether two or more persons associate as co-owners of a business for profit. This definition means that a partnership can come into existence simply based on the parties’ acting as partners even without a contract. Let me provide some legal precedents as examples:

UPA §٧(٤): “Receipt of a share of profits is prima facie evidence” that a partnership exists, unless … to substitute salary or to pay interest on a loan.

[_*Fenwick v. Unemployment Comp. Comm._][ *]- Beauty shop owner made an agreement with a secretary. Court decision – agreement was nothing more than fixing compensation. To render the decision the court considered

Intent of the parties

Profit sharing

Loss sharing

Control of the business

Name of the business

How the parties were holding out themselves to the public

[* Martin v. Peyton -  *]friends lent money & got shares as collateral for the loan

Profits sharing? Yes, but to cover the interest on the loan

Control? Yes, but limited, just to make sure the business doesn’t go bankrupt, such as having veto rights & inspection rights, but not controlling daily operations

Court decision – they were not partners. The court explicitly stated that there is a “significant difference between lenders and partners”

Southex Exhibitions v. RIBA  - organized shows on a temporary basis

Profit share-55% to Southex, 45% to RIBA

Loss share-Southex only

Control-Mainly Southex (dates and ticket prices were mutually determined)

Holding out to 3rd parties (including IRS) – No

Name on contract – only “Agreement”, not “Partnership Agreement”

Term – 5 years and then renewable with mutual consent

Other – Southex said it wanted “no ownership”

Court decision – no partnership.

Young v. Jones (brokerage firms)

Partnership by estoppel (UPA § 16): When a person… represents himself… as a partner in an existing partnership… he is liable to any such person to whom such representation has been made, who has on the faith of such representation given credit to the actual or apparent partnership….

Just as the law views a general partnership as a default category, the law establishes certain default rules for governing a partnership when it exists without a partnership agreement. Those default rules often do not reflect the best interests of the partners but legally bind them when they have not established their own. For example, the partners in a general partnership share equally in the profits remaining after all liabilities are satisfied. This means that even if one partner does ninety percent of the work and invests ninety percent of the capital in the venture, the profits of the company still must be divided on a fifty/fifty basis absent an agreement to the contrary. The parties can always overwrite these general legal principles by entering into a formal written partnership agreement. This agreement is usually a detailed all-inclusive document, which stipulates present as well as future relationships between the partners and between each partner and the business. If there is a dispute between the partners, this agreement is the first document attorneys and courts are looking into. Accordingly, it should be carefully drafted and reviewed by an experienced business attorney.

Let’s review the duties and obligations of each partner in the partnership.

#
p<>{color:#000;}. Partners are co-agents of each other, meaning they owe fiduciary duties to other partners as well as to the partnership;

Partners are co-principals, meaning they decide jointly how to run the business, are jointly & severely liable for partnership debts

A duty of loyalty to the partnership and the other partners, but it is limited to the following (a) to hold as trustee any property, profit or benefit derived by the partner in the conduct of the partnership business or derived from a use of partnership property, including the appropriation of a partnership opportunity; (2) to refrain from acting against the partnership on behalf of an adverse interest; (3) to refrain from competing against the partnership.

A duty of care, but it is limited to refraining from engaging in grossly negligent or reckless conduct.

A partner shall discharge the duties to the partnership and exercise any rights consistent with the obligation of good faith and fair dealing

And now the rights partners have (the default rule, can be overwritten by the agreement).

#
p<>{color:#000;}. The proceeds should be fairly distributed between all partners after all obligations are met; and all partners must contribute towards the losses sustained by the partnership according to his share in profits.

All partners have equal rights in the management and conduct of management business

No person can become a member of a partnership without the consent of all the partners

Any difference arising as to ordinary matters connected with the partnership may be decided by a majority of the partners; but no act in contravention of any agreement between the partners may be done rightfully without the consent of all the partners

Dissolution

Dissolution sounds like the end of business, but it’s not…

Merely the end of the particular arrangement between the partners

Business can continue if:

Bought by a partner or third party

Dissolution was “wrongful” and business continued by other partner

Effect of dissolution – partners have no authority to act for the partnership (other than acts to wind up the business), but can still bind partnership in certain circumstances (e.g. a 3rd party didn’t know about dissolution)

Possible causes of dissolution:

End of definite period or completion of undertaking (no violation of agreement)

At will if no definite period or particular undertaking (no violation of agreement)

Mutual agreement (no violation of agreement)

Bona fide expulsion (no violation of agreement)

Event making the carrying on of business unlawful (no violation of agreement)

Death (no violation of agreement)

Bankruptcy of partner or partnership (no violation of agreement)

Court order under § 32 (lunacy, incapacity, prejudicial conduct, willful or persistent breach (or really bad conduct), business a loser) (no violation of agreement by petitioner)

At will even if definite period or particular undertaking (violation of agreement)

Does it matter whether dissolution was wrongful, i.e., in violation of agreement? Yes, because

Non-wrongful dissolver can have damages for breach

Non-wrongful dissolver has right to continue business (but must cash out wrongful dissolver for the value of its share less damages caused by wrongful act)

What distinguishes a partnership from a corporation? Unlimited liability, taxation, limited lifetime, centralization of authority, transferability of claims, standardization vs. tailoring.

Not-for-Profit Corporation

A not-for-profit corporation is a company has a public purpose and all income and profit is permanently dedicated to that purpose and may not be shared with private individuals. Not-for-profit corporation cannot have shareholders or investors. It is managed by a board of directors, trustees, and/or employees. Such type of entity is best suited for a businesses organized for charitable, educational, artistic, scientific or religious purpose.

Pros:

Corporation does not pay income tax

Donations made to a 501©(3) not-for-profit corporation are tax deductible for the donor

Tax deductible fringe benefits, including health insurance and retirement plans

Sales and property tax exemptions may be available

Managers liability for business obligations is limited – lawsuits are brought against the company rather than the individuals

Cons:

Any profit that a not-for-profit corporation earns on the products/services it provides or on the investments it makes must be applied to the operation of the corporation and cannot be distributed to its members, officers, and directors.

Expensive and difficult to create – requires many additional filing with IRS to obtain a tax exempt status

Administrative duties may be complex to set up, operate and dismantle the company

No shareholders. Corporate assets are deemed to be owned by the public (upon dissolution of corporation, its property must be transferred to another not-for-profit corporation or to the state).

Benefit Corporations

Historically, in the United States, the main goal of the corporations was to maximize economic value for its shareholders. This goal was first explicitly stated in Dodge v. Ford Motor Company in 1919. Then many other legal precedents confirmed this principle. Actually it is the primary fiduciary duty of the corporate directors and all their actions must be done with this consideration.

Companies that wish to pursue any public purpose, other than material value for its shareholders, are, traditionally, not-for-profit corporations. These corporations do not have shareholders, do not distribute profits to individuals, but are managed by the board of directors or trustees and all earnings are devoted to the public purpose, such as charitable, educational, social, religious and alike. Upon dissolution of the not-for-profit all assets of the company must be transferred to another qualified not-for-profit.

There was no legal structure that would allow entrepreneurs to receive profits and at the same time accomplish their social or environmental missions. To fill this void a benefit corporation was created. Presently this legal structure is accepted in 30 US states and the District of Columbia.

A benefit corporation is a legal structure best suited for businesses that have a public purpose and positive impact on society, community and environment in addition to earning profits. Benefit corporations function like regular corporations, are allowed to engage in all kinds of business activities, treated like a regular corporation for tax purposes, but the fiduciary duty of directors is expanded allowing them to consider not only financial interests of its shareholders, but the interests of other constituencies, to pursue the mission the company was created for besides earning financial profits. If in a traditional corporation, shareholders judge the company’s financial performance, in a benefit corporation, shareholders judge performance based on the company’s social, environmental, and financial performance.

Usual major provisions of a benefit corporation are:

[* Purpose -  *]shall create general public benefit.

Accountability – directors’ and officers’ duties are to make decisions in the best interests of the corporation while considering the effects of their decisions on shareholders, employees, customers, community, environment, etc.

Transparency – shall issue yearly Benefit Report in accordance with third party standards. The report must be available for review to all shareholders and on the public website with exclusion of proprietary data

Right of Action – only shareholders and directors have right to bring a legal action in the court, which can be for 1) violation of or failure to pursue general or specific public benefit or 2) violation of duty or standard of conduct

Change of Control/Purpose/Structure – shall require a minimum vote, which is a 2/3 vote in most states, but slightly higher in a few states

Benefit corporation laws were created for the entrepreneurs who wish to raise capital and grow their businesses while pursuing social or environmental mission.

When do I need to register a company?

Often entrepreneurs start working on a business idea/product/service and postpone registering a company until they know that their business concept is a valid one. At a certain point, however, entrepreneurs will need to incorporate. How do they know when is the right time?

More than one person is involved. If several people are working on a business as partners their agreements and understandings are better be put in writing. Moreover, the law views such relationship as a general partnership by default and imposes certain regulations, which may come as a surprise to the parties. One of the most drastic ones is that each partner is fully personally liable not only for his own actions, but for the actions of his partners as well.

Intellectual property is being created. If there is more than one partner, it is important to assign all IP to the company. The law states that IP belongs to its creator automatically upon creation. If there are no agreements in writing and a person leaves unregistered business arrangement, he can take all IP developed by him and if something was developed in cooperation with others, it may be problematic to use it without a written consent of everyone involved.

Hiring employees. Employer-employee relationships are governed on both state and federal level. If there is an issue, it is undoubtedly better if a claim is brought against a company, not an entrepreneur individually.

Issuing stock options. Many entrepreneurs working on the initial development of business do not have spare funds, but need professional help. For this reason equity compensation became so popular in the world of startups. Although it is possible to enter into some pre-incorporation written agreements, it is easier and more straightforward to already have something to be granted instead of making unsupported promises.

Launching a service / product. Here the issue of personal liability emerges. A properly registered company is considered a separate business entity. If there are any claims, they are brought against the company, not its owners individually, and the company’s assets are at stake, personal assets of its owners are protected from the creditors.

Starting capital gains holding period.  If a founder sells stock at a profit, which he held for more than one year, his income will be taxed at the rate of long-term capital gains, which is much lower than tax rate for ordinary income (15% for people with annual income below $400K and 20% on the income higher than $400K/a year). Nowadays exits events happen pretty quickly. An entrepreneur may develop an app, online platform, product or service and sell it to a bigger company. If he registered a company not long before his stock is sold, all income he receives will be taxed as his ordinary income at the rate depending on his tax bracket. Considering the said, it makes sense to incorporate at the earliest stages of development.

Looking for investments. Investors invest in the companies and usually receive stock in the company in exchange of their investments. They do not give money to individuals for many objective reasons, the most obvious one being that we all mortal. It is not an easy task to find an investor and then to convince him to invest. Gone are the days when money was given to a group of people working from a garage. Nowadays investors want to see how serious entrepreneurs are about their business. Not to mention that investors may not wait until an entrepreneur will go through all legal formalities to register a company. There are always many lucrative projects on the market and other players may be quicker and more accommodating.

What state should I incorporate in?

It depends on the nature of your business. Certain states have a reputation of tax haven. Usually it means that there is no state tax, provided that the company is not conducting business from the state. However, all companies/individual entrepreneurs have to pay federal taxes. When you hear someone calling these states ‘American offshores’, keep in mind that while state taxes or the absence thereof may be lucrative, it does not mean that an entrepreneur/company won’t have to pay taxes at all. Moreover, often these states impose a franchise tax for the opportunity to incorporate there.

Having said the above, incorporating in a state with a certain tax structure may be beneficial for business which do not have a psychical location in another state, e.g. online businesses. The law in U.S. is fact-based, not paper-based. Meaning, if a company is incorporated in Delaware, but has a physical location in New York (office, employees, conducts business from NY, solicits state residents), it’ll be subjected to NY state taxes regardless. This explains why the state of incorporation should be determined in accordance with the nature of the business. It may not make lots of sense for companies that run business from a physical location to incorporate in so called tax heavens. Simply won’t help. The story is quite different with online businesses. Having been experiencing the boom of tech startups for the past five years, we see that more and more companies transfer their commercial activities online. Remember chain bookstores just a few years ago? How many people buy books from a brick store nowadays?

What would be the recommendation for an online business or the one, which conducts its activities in multiple states (cannot be tight to one particular location)? Any other state, which provides certain tax reliefs. It can be Nevada, Texas, New Jersey, Alaska, Florida, Tennessee, Washington, Wyoming, New Hampshire, South Dakota, and, of course, famous Delaware.

What if we talk about a startup, which is going to look for venture capital?

Delaware.

Why?

Well-developed and predictable body of law

A separate Court of Chancery which reviews only corporate claims (accordingly dispute resolutions happen faster and more efficiently)

Directors and officers of DE corporations are awarded greater protection from liability

Complying with procedural formalities is easier in DE (e.g. was one of the first states which implemented electronic submission of annual reports and other mechanisms of regulatory compliance), and

Investors insist on Delaware.

Nowadays many other states, like New York and California, have well-developed corporate law, which is hardly worse than Delaware one. Delaware continues to be the leading state for incorporating mostly from practical perspective rather than a legal one. Investors insist on Delaware. Why? Mostly often investors are people/companies, which have been functioning in the corporate world for a while. They are familiar with Delaware law, they have their own counsels, who are familiar with Delaware law, and they know all ins and outs, procedures and possible consequences. It is not practicable to educate oneself about laws of other states only because of one startup in which they may have interest. It is not a secret that there are more entrepreneurs looking for investments than there are investors ready, willing, and able to render the cash. Accordingly, startups are advised to make it easier for potential partners to come on board.

[] What is a Certificate of Incorporation and Bylaws?

A corporation is considered to be formed when a Certificate of Incorporation is filed with the Department of State. It is a brief document which addresses the basics such as the name of the entity, address, total number of shares being authorized, the address of a registered agent for a service of process, the general statement of business purpose (usually to conduct any legally allowed activity).

However, certain provisions that may be desirable to business owners may not be enforceable if they were not included in the filed Certificate of Incorporation even if they are stated in other corporate documents. Such provisions are indemnification, pre-emptive rights, voting rights, supermajority voting, limiting the powers of directors or stockholders, and others. For this reason, among others, it is important that the company is being formed by an experienced business attorney, not one of the online services, which file the basic simplest document required by the state to effectuate the registration and do not have any responsibility to its customers for the consequences.

Bylaws set forth various procedures relating to the governance of the corporation, such as duties and responsibilities of the directors and officers, number of directors to be elected, how director and shareholder meetings will be called, voting and proxy, where corporate books will be held, notices to be submitted and other general corporate matters. Bylaws do not regulate the relationships between shareholders towards each other and the company, do not grant or restrict any shareholder rights and responsibilities and do not address any other matters relevant to the ownership of the company’s shares. Such matters are included in the Shareholder Agreement.

How many shares should be authorized in the Certificate of Incorporation?

There should be enough shares not only for the present founders, but also with consideration of bringing on additional partners, investors, granting equity compensation to the employees/ independent contractors. There is a difference between authorized shares and issued shares. Authorized shares are shares the company can potentially issue at any given time. Issued shares are the ones that have already been granted to someone, which are spoken for. Here is a danger various online company registration services present. The goals of the founders and possible business scenarios should be discussed with an experienced business attorney before any documents are filed with the Department of State. A standard form is not suitable for most businesses, but this is exactly the one being filed by online service providers. Think how simple the transaction is when retaining the services of online providers – you pay with a credit card and receive a company’s registration. That’s all. No one inquires what your business plans are, no one explains to you various options, offers additional protections and benefits of including certain terms, etc. also they do not carry any responsibility in case of unfavorable consequences as licensed professionals do. Then the logical question is what kind of quality can be expected? In the best case, business owners will have to pay to the attorney to revise the documents, which have already been filed (e.g. when investors review the company’s documents, they want to see certain provisions being included). In the worst case, owners will loose their interest in the company (e.g. in case their interest is diluted by issuing additional shares which was voted upon by a simple majority) or incur personal damages and realize the company cannot compensate them, and many other unfortunate events, which could be predicted and protected against by properly composed and registered documents.

Having said the above, I usually advise companies to authorize 10 million shares, with 8 millions being issued to the founders, and 2 million being left in the option pool for future grants in any. When company is small, there are just a few founders, it des not matter how many shares each has, but the percentage of his interest in the company. For example, 8 million shares can be divided two to give 50% interest to each the same as 1 million shares can be divided in two with the same outcome in terms of interest in the company. However, once the business grows, the market value of the company increases so is the value of each share. Should the company/founders want to do additional grants, the price of each share in 8,000,000 is undoubtedly less than if the value of the whole company is represented by 1,000,000 shares. Having more shares initially authorized at the time of company formation allows avoiding stock splits later on and all legal procedures and expenses associated with the process.

What par value and no par value means?

Par value means the minimum price per share it is issued at. Typically we put $0,0001 per share at the company’s formation so that founders can purchase the amount of shares they desire.

No par value stock means there is no baseline at what price it can be sold. Not all states allow registering no par value stock. Setting minimum par value helps to solve this issue.

Founders Stock and associated features

Nowadays companies emerge, develop, and get sold pretty quickly (sometimes as quickly as in a few months). Most exits of startup companies arise opportunistically rather than from planned long-in-advance transactions. Business climate requires law to follow the course. In order for the markets to function efficiently the laws must be aligned with the new business concepts and satisfy the needs of market participants.

Class F common stock is a recent legal development in the world of startups. What’s the difference from a regular common or preferred stock we get used to?

Class F common stock.

It is not a secret that founders may loose some control over their enterprise once they bring investors and their share in the company gets diluted. Class F common stock was developed to protect founders’ interests while getting financing. It includes a number of founder-friendly provisions. “F” in its name stands for “Founders.”

Voting. While common stock has one vote per share, Class F common stock has 10 votes per share

Protective provisions . Certain actions that are considered to be vital for the company cannot be taken without the consent of holders of more than 50% of the Class F common stock.

Directors. Holders of Class F common stock are allowed to elect at least one director. This is helpful in a situation when the size of the board has to be small. This provision ensures founders are not squeezed out from the board.

The Class F common stock and regular common stock participate equally in dividends distributions and other economic rights. The Class F common stock can be converted into regular common stock any time at the option of its holder. It is automatically converted into a regular common stock if the holder dies, the Class F common stock is transferred to someone other than another Class F holder or an entity for the benefit of a Class F holder.

Should founders pay for their stock in cash or contribute intellectual property?

If a founder owns intellectual property, which he plans to assign to the company, he may want to use it as a payment for his stock instead of paying cash. It can certainly be done and it will be a valid form of consideration. However, there are some risks associated with paying for stock by assignment of IP rather than with money. Depending on the nature of IP it may be:

Difficult to fully and accurately describe the scope of assignment

Difficult to put monetary value on the assigned IP

Putting a monetary value on assigned IP can affect the price of company’s stock, which have to be accounted for in tax documents (it is usually recommended not to trigger valuation event without necessity)

Potentially bring tax ramifications (the contribution must be reviewed by an experienced accountant to ensure it is tax free for a company)

Typically when a company is registered par value of its stock is set at $0,0001 per share and this is the price founders have to pay for their shares. Even if a founder acquires 4,000,000 of the company’s shares, the price he has to pay to the company is $400. Accordingly, I usually advise founders to pay cash for their shares to avoid any issues. If there is an IP to be assigned to the company regardless, I prefer to effectuate it by a separate assignment agreement unrelated to the value of the company’s shares.

Should Founders Stock be subject to vesting?

When companies hire personnel and give them equity compensation as part of the package, usually founders are very careful to impose certain vesting structure to ensure that an employee will stay with a company and invest his/her resources for a certain period of time instead of leaving in a months with a big chunk of interest. When a group of people come up with an idea and decides to build a business based on it, the subject of vesting does not necessarily come up. Should it? Should Founders Stock be subject to vesting?

There are two main points of views on this subject. Both have legitimate grounds. Some believe that those who invested their financial and intellectual capital, time, labor, and otherwise devoted themselves to the creation and development of the business from the very beginning, should fully and unconditionally own their share in it. On the other hand, we all agree that establishing a business is only the fist step. The success and further development of enterprise greatly depend on the work of all parties involved. The partners may not want anyone to leave a company shortly after its creation and still own a big chunk of interest in case business grows significantly due to no help from that person. The vesting may be a reasonable solution.

Also, we know that if investors get involved, they impose vesting on founders’ shares almost in 100% of the times before they put money on the table. When making a decision of whether to invest, investors review the team as much as they review the product/service/idea. They will surely put some mechanisms in place to ensure that some members of the team won’t cash out shortly after receiving the money or, even worse, will hold to their shares for a period of time and then come back for profits when the business is at its peak. If founders impose a reasonable vesting schedule on their shares, it may survive after investors come on board, which will allow avoiding re-writing company’s documents and incurring significant legal costs.

If vesting is imposed, what are the typical vesting terms?

Vesting can be structured according to the parties’ business goals. It can be performance-based or time-based. A typical one and most commonly used is a four-year vesting with a one-year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares.

What is an 83(b) election?

Failing to make a timely 83(b) election with the IRS could have serious tax ramifications for a startup founder or employee who owns shares in a company that are subject to vesting. The general rule is that taxes are due when a person receives income. The value of the shares is certainly considered income, regardless whether it’s realized or unrealized. A person does not receive a profit if the ownership of the shares is conditional, subject to forfeiture (if vesting is imposed, it is, because company has the right to forfeit unvested shares if certain conditions are not met). Taxes are due only if and when the ownership becomes unconditional. What it means in terms of tax schedule? If stock were subject to a four-year vesting and a certain % of shares vests on monthly bases, a holder would recognize income equal to the difference between the fair market value at the time of vesting and the value at the time he/she received the shares. This income is taxable. Even if the holder does not sell shares, he/she has to come up with money to pay taxes. What makes it worse, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

Not everything is so gloomy if an 83(b) election is timely made. If a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock. For example, a founder purchases stock for $0.01 per share and the stock is subject to four year vesting with a one-year cliff. The founder makes an 83(b) election and pays all taxes due at the time of purchase (based on a fair market value of $0,01 per share). At the end of the one-year cliff, if the stock is worth $1.00/share when it vests, the founder recognizes $0.99/share of income. Without 83(b) election, the founder would have to pay tax on the profits, which are equal to $0.99 per share. Then as the remainder vests each month, the founder would receive income equal to the difference between the fair market value and $0.01/share (the amount he bought it at). By making an 83 (b) election the founder pays takes on unvested shares at the time of purchase when the value is usually minimal. Then no tax is due at the time of vesting, when market value can grow significantly. The holder will not have to pay taxes until he/she sells the share at a profit.

Another benefit is that recognizing the purchase of all shares, including unvested ones, starts the count towards the asset-holding period. When a person sells assets, which he held for longer than one year, the income received from such sale is taxable at the rate of long-term capital gains, which is much lower than ordinary income rate.

Thus, a founder/employee of a startup should almost always make an 83(b) election.

It is important to notice, that an 83(b) election will be effective only if timely made. It should be filed with IRS prior to the date of the stock is received or within 30 days after the stock is received. There are no exceptions to this rule. 30 days are calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. If purchased on November 15, an 83(b) election should be filed before December 14. Accordingly, it is vitally important that all transactions involving shares/equity interest in the company are supervised by an experienced business lawyer. The consequences of small mistakes or overlooks can be irreversible.

What does Incorporator’s Organizational Action mean?

The company may be registered by any physical person at the age of 18 or older. Usually the business attorney does it. This person is called an incorporator. Once registration is done, the incorporator has to adopt and put in writing certain resolutions with respect to the initial organization of the corporation, particularly:

Adoption of Articles of Incorporation

Adoption of Bylaws

Sale of Common Stock

Basically formally transferring the shares to the owners of the company, which looks like this:

Name of the shareholder – number of shares being transferred – consideration paid by the shareholder for his shares

Adoption of Form of Common Stock Certificate

Election of Directors to serve before the first meeting of shareholders

Election of Officers to serve before the first meeting of directors

Stating the fiscal year for the company’s accounting

Qualifications to Do Business

Authorization to open a bank accounts for the company

Authorization to obtain an employer Identification Number

Authorization to pay expenses

Authorization to withhold taxes

Any other matter that may be relevant to the company organization,

And then resigns as a Sole Incorporator “the undersigned, being the Sole Incorporator of the Corporation, having taken all actions necessary and appropriate in connection with the incorporation of the Corporation, does hereby tender the undersigned’s resignation as the Sole Incorporator to the Board of Directors as constituted above.”

What is Unanimous Written Consent of the Board in Lieu of Organizational Meeting?

Once the corporation is formed and the incorporator transferred shares to the intended owners, the directors of the company have either to ratify the actions of the incorporator or make new decisions. Usually all actions of the incorporator are ratified because those are negotiated and agreed upon with the company’s owners before the company formation. This can be done by conducting a meeting of the company’s directors or by written consent if there is unanimous agreement between the directors, which safes time and effort. The provisions such initial written consent usually contains are the following:

The actions of the incorporator are either approved and disapproved;

Reimbursement of expenses that were incurred during the incorporation procedure by the company

Adoption of the by-laws

Adoption of the stock certificate

Adoption of the corporate seal

Election the officers of the corporation

Giving or limiting authority of the officers

Authorizing officers to open and maintain one or more bank accounts for the corporation

Stating the fiscal year of the corporation

Any other ratification related to the organizational matters

What documents are typically included in a company organizational package?

Certificate of Incorporation to be filed with the Department of State

Bylaws or operating agreement if LLC

Organizational Action By Incorporator

Organizational Board Consent regarding organization and corporate governance matters

Application for Employer Identification Number

Application for qualification to do business as a foreign corporation in the state in which the company is located (if different from the state of registration)

Corporate records and minute book

Stockholder Consent regarding organization and corporate governance matters

Please remember one form does not fit all. Most of the basic forms available online for download are not suitable for accomplishing all goals and protecting the interests of the companies’ owners. Entrepreneurs are strongly advised to obtain a comprehensive consultation with an experienced business attorney before proceeding with the company registration.

Who are considered the owners of the company besides founders?

The owners usually are comprised not only of the founders, people who contributed financial or intellectual capital, but also frequently of key management personnel that are identified as being necessary for the success of the venture. Some people refer to them as the “five C’s” (CEO, CMO, COO, CTO and CFO).

The CEO – chief executive officer

The CMO – chief marketing officer

The COO – chief operations officer

The CTO – chief technology officer

The CFO – chief financial officer

Although not required, it is common for the five C’s to receive some level of stock rights in connection with their commitment and service to the start-up. Some or all of the roles of the five C’s can be filled by founders, provided founders have necessary skills and talents. Otherwise, it may be better for the business to bring more experienced or educated professionals in a particular field from outside. Imagine a situation when a founder is extremely talented IT engineer, developed an outstanding product, but knows nothing about marketing, business development, and sales? Or he loves what he does in a laboratory and has no interest or desire to go out and socialize with strangers to improve sales? How soon do you think the business will pick up? Not even to mention the possible competitors on the market …

Owners of the company can also be other key employees when it is desirable to incentivize them to stay and perform or to reward for loyalty and service already given. Once all owners are identified, the next step is to decide how much of a percentage interest they should receive and in what form that interest will be granted. There is no legal or any other requirement concerning this matter. There may be some industry standards, which may be used as solely as guidance (to get an idea if you are knew to the market), but generally it is open to a discussion between two market participants.

Once there is an understanding of how the percentages of ownership should be aligned, then various elements of the company management, owners’ rights and responsibilities, exit strategies, warranties and other matters, which may affect business operations should be considered and agreed upon. At this stage you need assistance of an experienced business lawyer.

Conducting business in other states

When a company conducts business in a state other than the one it is incorporated at, it may have to apply for authority to do business in that other state. Whether it is mandatory or optional depends on the regulations of each particular state, which should be consulted before any commercial activities are taking place. As a general rule authorization to conduct business is required to obtain a state license, bring a law suite in the state courts, submit state taxes if it is owned either from the profits generated from that state or the ones companies are holding as trustees (e.g. employment, sales, use taxes, and alike). If it is a state requirement that all foreign companies (registered in a different state of the US) get authorization to conduct business in a state and a company does not apply for one, great penalties may be incurred, the amount of which again depends of the state of violation. Obtaining a qualification to conduct business is a simple straightforward process, which may be accomplished expeditiously. There is definitely no reason to risk business reputation and possible penalties. Business owners are advised to establish professional relationships with an experienced business attorney whom they can consult on a regular basis during the development of their enterprises.

Explore the decision-making process

I am an entrepreneur, have a business idea/product/service, did research and have a strong basis to believe it is a viable one. Want to establish a business. Where do I begin? What should I consider first, second, third?

#
p<>{color:#000;}. Are you alone in business or do you have partners? If have partners, do you have a partnership agreement or at least a letter of understanding in writing?

Register a company to protect you from personal liability and properly document the ownership of the business assets

Select the proper legal entity for your business

Decide in which state to incorporate considering the legal requirements of prospective locations

Consider which legal provisions to include in the Certificate of Incorporation

If forming a corporation, decide how many shares you need to authorize not only for present but for possible future purposes (e.g. accepting investments, giving equity compensation to employees/contractors, bringing new partners on board, etc.)

Prepare all corporate organizational and operational documents (Bylaws, Incorporator’s actions, Board of directors’ ratifications, etc.)

Develop a detailed shareholder agreement

If there is more than one founders, consider whether imposing vesting on founders’ shares may be in the interests of all involved

Consider all special features available for the founders’ stock and decide whether you are going to implement it

In which states are you going to conduct business? Consult a business lawyer whether you need to file for an authorization to do business in those states?

Do you need licenses for your business?

Are you retaining the services of independent contractors/employees? Did you familiarize yourself with the state and federal employment laws? Did you document your relationship? Did you address the assignment of intellectual property if being developed?

Did you execute an assignment of intellectual property from individuals to the company with all partners?

Is intellectual property properly registered if it is subject to registration?

What legal documents do you need for your commercial activities (sale agreements, service agreements, licenses, other transactional documents)?

Do you know all regulatory requirements that may be relevant to your business? Did you put certain mechanisms and checks in place to ensure ongoing legal compliance?

Did you have a comprehensive consultation with an experienced business attorney to discuss all above items in detail and receive further guidance to make sure your business goals won’t be disrupted by legal mistakes?

CHAPTER 2

Operating agreements, shareholder agreements, founders’ stock agreements

What is Founders’ Equity Sharing Agreement? What terms should it contain?

The Founders Equity Sharing Agreement is a legal document, a written agreement between the founders of the company before they register a business entity. Upon registration of the company the terms of the founders agreement are usually incorporated into a shareholder agreement or LLC operating agreement depending on the entity type.

The Founders Equity Sharing Agreement should contain all oral agreements of the founders and of course the equity sharing matter. The usual terms it addresses are:

#
p<>{color:#000;}. events that may invalidate the current agreement and require a new agreement to be developed (e.g. receipt of outside investment, acceptance of a new equity partner, change of business entity type, etc.)

division of shares between the founders

present and future capital infusions

the event if one of the founders is unable to meet the capital infusion call

vesting on founders equity interest

non-compete

assignment or licensing of intellectual property

authority of each founder to make business decisions independently or upon mutual agreement with other founders

death or legally incapacity of a founder

any other matter that was discussed and agreed upon

What is a shareholder agreement and what are the terms it must contain?

Corporate Shareholders’ Agreements address the rights and responsibilities of the shareholders towards each other and the company, the restrictions and preferences associated with different class of stock if any, methods and procedures of taking actions related to the share ownership, company management, exit strategies, warranties and other matters, which may affect business operations. This agreement must be extensive and detailed to cover the interests of all parties and all possible future developments. The most common provisions

Management Provisions

Board of directors

Director and shareholder meetings

Voting arrangements

Deadlock

Subsidiaries

Transfer of Interest

Restriction on transfer

Right of first refusal

Drag-along rights

Tag-along rights

Pre-emptive rights

Anti-dilution

Valuation

Payment terms

Co-sale

Non-compete and other agreements

Non-compete

Confidentiality

Corporate opportunities

Information Rights

Financial statements

Inspection rights

Representations and warranties

Terms and termination

Release of liability

Reimbursement of expenses

Successors and assigns

Third-party beneficiaries

Governing law and jurisdiction

Dispute resolution procedures

Dissolution

Shareholder agreements usually apply not only to the present shareholders but future ones as well. Attorneys include the provision stating that in case of interest transfer the transferee must sign an agreement to accept the corporation’s shareholder agreement. It ensures that interest of the present shareholders will not be affected by any future transactions. The shareholder agreement is one of the most important documents of the company and accordingly should only be drafted by an experienced business attorney. There are no sample documents that cover all possible interests of the parties and protect from all possible liabilities. The danger with forms that are available for download online is not that they may contain legally unsound provisions, but that they are extremely limited. A person, who is not a business attorney, is able to see only what is included there, but cannot know what else is available, foresee all possible consequences, and fully understand legal interpretations under existing corporate statutes and legal precedents. It is strongly advised to discuss the nature of the business and interests of its owners with an experienced business lawyer.

LLC Operating Agreement and the terms it should contain

When several people come together to do business, have an understanding of how the percentages of ownership interest will be divided, and decide to form a limited liability company (LLC), they as the owners of LLC are called members. (As a comparison the owners of a corporation are shareholders. Different type of entity involves different legal terminology). The next step is to consider various elements of company management, owners’ rights and responsibilities, exit strategies, warranties and other matters, which may affect business operations. LLC operating agreement combines all of the said agreements and regulates the way business is conducted as well as the relationships between the owners of the LLC. The goal of the Agreement is not only to establish certain rights and procedures relevant to the present business goals, but to predict all possible future case scenarios and stipulate in advance how each will be resolved. Trying to deal with a problem when it emerges without having a certain plan or understanding will undoubtedly lead to disagreements and protracted litigation. Accordingly, LLC Operating Agreement should be a detailed all-inclusive document developed by an experienced business attorney.

Many various provisions may be included in the LLC Operating Agreement depending on the nature of business and relevance of each. I’ll review the most common and important ones.

Management Provisions

Management provisions in the Agreements are critical to effectively manage and control the operations of the company. The Agreements will set out the authority of each person, including the directors and officers which may include all of the Five C’s previously discussed. These agreements address in detail who may participate in the daily operations of the company, how decisions shall be taken and transactions be communicated to other members, inspection rights, compensation and many others.

Voting Provisions including Supermajority Voting Requirements

The Agreements will also set out the voting provisions. Usually all decisions are made by simple majority of the voting shares/membership interest (51%). The owners may negotiate in the Agreements that certain provisions (e.g. election of the board of directors, making changes to the Articles of Incorporation or the Agreements, issuing additional shares/interest, approving budgets, selling company assets, approval of the transactions with the affiliates, and capital contributions) require supermajority voting (75% of votes or above).

Restricting Transfers of Shares/Membership Interest

The Agreements should clearly set out any restrictions or obligations related to the shares/membership interest of the company and will typically include a general prohibition on transfers, or any rights or obligations under the Agreements except as specifically permitted in the Agreements or as consented to by the owners. There normally is some flexibility built into the Agreements so that owners can deal with their business interest efficiently for tax planning purposes – known as “permitted transfers”. For example, where the owner is an individual (e.g., a founder), such owner should ensure that the Agreement permits him to transfer his interest to a corporation wholly-owned by the owner or his family members, a custodian, trustee or other fiduciary for the owner and/or his family members, or any other person if such transfer is effected pursuant to the owner’s will. In case of a permitted transfer, the Agreement should state that any transfer is conditional upon the transferee agreeing to be bound by and becoming a party to the Agreement.

Confidentiality, Non-compete and “Assignment of Invention” Provisions

In a startup product or technology companies, the product idea or technology under development is often the most valuable asset of the company. It is critical to have not only confidentiality agreements respecting the confidential nature of the company’s information, but in many instances, noncompetition agreements with key employees and founders. The company must restrict those who have the capacity to impact the company’s success if their knowledge developed in connection with their service to the company or knowledge/product idea which they or others sold or transferred to the company for consideration, could be harmful if made public or used in competition with the company or transferred to a third party for use.

In the technology and product development communities, Assignment of Invention agreements are required to the extent such key employees or founders have rights to the same under law. These rights can be both brought to the company upon employment or can be acquired during employment as services are provided, so both instances must be covered. There are also Assignment of IP and Other Assets agreements entered into in which the owner of rights is assigning and contributing those rights to the company in exchange for compensation –which could be ownership equity in the company. It is also proper to have the spouse of the assignor sign these agreements to avoid any claim of marital property rights in the asset being assigned.

Other Common Provisions

Shareholders Agreements and Operating Agreements may also contain other provisions relating to the following:

– Anti-Dilution  - in order to prevent their ownership interest from being diluted by future issuances of shares, the owners may require that they be given the right to maintain their percentages of ownership by acquiring a proportional number of any new shares issued.

– Right of first refusal  - if an owner wishes to transfer his or her interest in the company, the company and other existing owners may request that first they are given the opportunity to buy the interest pursuant to the terms being offered by the third-party purchaser. If they fail to purchase the interest within prescribed time period, the selling owner is free to sell to the identified third party on the terms presented to the company and the other owners within a designated time period.

– Valuation  - it is critical that the method of valuing shares and membership interests be set forth. Valuation methods may change depending upon who the member or shareholder is that requires the valuation and the circumstances requiring the valuation to occur. Death, disability and withdrawal of an owner being the most common. In the startup venture arena, valuation for purposes of investor equity is of huge importance and impacts further investment potential once valuation is determined.

– Payment Terms  - once valued, if shares or membership interests are to be repurchased, the terms of repayment (number of payments, down payment, interest rate, security, voting during repayment, default rights) must all be put in place at the time the interests are reacquired by the company or a third party (if permitted as a transferee).

– Co-sale agreement – the owners may negotiate in advance that no third party can buy more than 10 percent of the interest in the company unless it purchases on a pro-rata basis the shares of all other owners who wish to sell at the price offered by the third party.

– Indemnification Provisions – it is important to include in the Agreements that the company shall indemnify any person who was or is a defendant or is threatened to be made a defendant in a legal action, suit or proceeding, whether civil, criminal, administrative (unless brought by the company itself) by reason of the fact that he/she is or was an owner, manager, employee or agent of the company or is or was serving at the request of the company, against expenses, judgments, fines, and amounts paid in settlement actually and reasonably incurred in connection with such legal action, suit or proceeding if other owners determine that he/she acted in good faith and in a manner he/she reasonably believed to be in the best interest of the company, and in case of a criminal action proceeding, has no reason to believe his/her conduct was unlawful.

– Jurisdiction and Governing Law  - important to be clear if the requirements of law of a particular jurisdiction are to be applied and a convenient forum used in the case of litigation.

[*- Death, Incompetency, or Bankruptcy of Member *]- the owners may agree that on the death, adjudicated mental or physical incompetence, or bankruptcy of a member, the company or other members should have the rights to buyout the interest of such member at a price determined by the independent appraiser. In case the company chooses not to exercises its right, the successor in interest to the owner (whether an estate, bankruptcy trustee, or otherwise) will receive only the economic right (to receive distributions of the profits) unless and until a majority of other owners vote to admit the transferee as a fully substituted member (meaning the transferee will receive economic value, but will not be able to vote or otherwise participate in the management of the company).

– Co-Terminus Provisions  - it may be prudent to provide that termination of rights as a shareholder or member also terminates the rights as an officer, director or manager as the case may be. Frequently, these provisions specify that the terms of any employment or similar agreement that are not dependent upon share or membership ownership are not affected by the sale or transfer.

– Dissolution  - consideration needs to be given to whether or not the owners of the entity should agree that the entity cannot be dissolved except by a certain percentage of votes and that otherwise, shareholders and members waive any right to seek dissolution.

The list above is far from being inclusive. It is just a demonstration of the key issues that should be discussed, agreed upon and put in writing before distribution of the company interest. Since the owners of the company may change or human memory may deteriorate during the life cycle of the business it is vitally important to have a good written, all-inclusive, specific and non-ambiguous LLC Operating Agreement, which will serve as guidance and help to avoid disputes later on.

Possible Legal Issues with a Former Partner and How to Avoid Them

The present realities are that many entrepreneurs work on the projects with other parties without officially forming a business entity. The reasons may be different. The prevailing ones are to save costs and/or to wait until they are confident in the viability of the business. It is important to know how such business relationships are viewed according to the law and what provisions the law imposes on the participating individuals. When there is no formal agreement in writing, the law establishes certain default rules for governing such partnership. Those default rules often do not reflect the best interests of the partners but legally bind them when they have not established their own. Let’s review the main rules and some equitable defenses that help to prevent a total windfall to one party if it contradicts with the initial understanding of the parties.

A general partnership is the default business form when more than one person operating a business. In other words, if two or more people run a business without taking the steps to incorporate, the law automatically views them as general partners. [*The legal test for determining if a partnership has been formed asks whether two or more persons associate as co-owners of a business for profit. *]This definition means that a partnership can come into existence simply based on the parties’ acting as partners even without a contract.

In addition to the paramount consideration of limiting your liability by the formation of an LLC or corporation, it is important to understand how the law views the relationship between you and your cofounders and what provisions the law imposes on that relationship, especially if you have not yet agreed among yourselves what your relationship is and how it is governed.

Just as the law views a general partnership as a default category, the law establishes certain default rules for governing a partnership when it exists without a partnership agreement. For example, the partners in a general partnership share equally in the profits and surplus remaining after all liabilities. This law means that even if one partner does ninety percent of the work and invests ninety percent of the capital in the venture, the profits of the company still must be divided on a fifty/fifty basis absent an agreement to the contrary.

Once this default partnership has been formed, however, the possibility remains that a partner will decide to leave the project, whether due to disagreement over how to manage the business or simply because she no longer can or wants to be part of the project. Such a scenario ends the partnership and triggers three technical procedures that law requires be observed.

First, either an event or agreement triggers the dissolution of the partnership. For example, an event triggering dissolution of the partnership might simply be that a partner had too many other obligations or moved and said, “Sorry, I cannot continue working on this project with you. Bye.” at which time the partnership would be legally dissolved. Or an agreement provision might be that the partnership would last only until a certain milestone in the project was reached, and having reached that milestone, the partnership automatically dissolved. A partnership can even be dissolved when the partners simply no longer associate as partners.

The reasoning for such an easily triggered dissolution is based on the “aggregate” legal theory followed by New York and many other states. Any time a partner leaves a partnership, the partnership technically dissolves and becomes a new partnership. Thus, dissolution is not a question of whether the business continues to operate or not but whether the identity of the partnership—based on the aggregate of partners—has changed.

When a partnership has been dissolved, the business cannot simply be stopped immediately; it remains to go through the winding up stage. One reason for the winding up stage, at least in an instance where not only the partnership but also the business itself will cease to operate, is to allow for an efficient closing of the business (for example, a store doesn’t typically close its doors the same day its owners decide to end the business but first tries to sell off most of its inventory, perhaps finish its lease term, etc.). But legally, the most important part of winding up is the accounting—the calculation and allocation of the assets of the partnership to the partners, either in equal shares, if they have no other agreement, or according to their partnership agreement. In fact, the law states that a partnership cannot be wound up without an accounting.

Finally, after the dissolution and the winding up are completed, the partnership ends upon termination, but remember the business can live on in a new partnership or other form. For our purposes tonight, we will assume that no argument occurred or remains over which partner keeps the business and which one leaves.

Having looked at the proper procedure for the departure of a partner, we ought to now see what risks arise from not following these procedures. You may wonder why anyone would not follow the three steps, but the informality and transient nature of startups plus the cost of professional legal and accounting advice often leaves such new businesses in a state of legal limbo. For example, if partners part ways without an accounting, especially if one continues the business on her own or with a new partner, what could happen if the former partner reappeared and claimed part of the business? To begin, a former partner can sue for an accounting of the dissolved partnership up to six years from the time she left the partnership.

A former partner only has a right to an accounting of the partnership property based on its state on the dissolution date, that is, when she left the business. However, although an accounting would be based on the value of the partnership on the dissolution date, the former partner has the right to demand either interest on her share of value remaining in the business or the profits derived from her share of value the business continued to deploy to its profit after the dissolution. If the former partner sued for those profits, the court would calculate them by determining what percentage of the partnership’s equity belonged to the partner at the time of dissolution—perhaps even fifty percent—and award her that same percentage of the profits earned since the dissolution date.

Were a business to become profitable or valuable in the future while a supposed former partner legally remained a partner, that former colleague could have a claim on profits or assets far beyond her level of contribution to the business, hence the importance of establishing that no partnership remain between former partners. There may be some equitable defenses to prevent a total windfall, however, such as laches, or substantive defenses challenging the plaintiff’s status as a former partner. But remember, even a victory in court by the current partnership can prove ruinously expensive.

The most efficient and effective ways to prevent such a debacle are to simply have an accounting or, in the case of a very small startup, simply sign an agreement between a partner and a former partner that they waive their rights to an accounting. One incentive the current partner can offer is to indemnify the former partner against any liabilities arising from her time as a partner.

In addition, there remain some residual tasks to cover other bases for liability. Notify any third parties, especially creditors, with whom the former partner may have been used to deal on behalf of the business that she no longer has the authority to bind the business in any form of transaction. And seek the advice of an accountant to make sure whether you must file any documents or owe any taxes in connection with the changes to the business structure.

Finally, many new entrepreneurs fear the theft of their business idea in a scenario like the famous legal dispute between the Winklevoss brothers and Mark Zuckerberg over the rights to Facebook. The concern raises the question whether a former partner can sue the ongoing business for having stolen her idea. However, ideas without a particular protection of law cannot establish a legal claim.

Under New York State law only contracts, such as non-disclosure agreements, to protect concrete, novel ideas can protect a business idea. Federal intellectual property registrations—trademarks, copyrights, and patents—protect particular forms of other ideas. In the absence of such agreements or IP rights, the current business faces little risk of litigation over a business idea from a former partner.

Hackathons – Possible Legal Issues & How to Avoid Them

Over the past year, hackathons have become immensely popular. A [*hackathon *]is an event where programmers and others involved in software and hardware development, come together, form teams around a problem or idea, and collaboratively code a unique solution from scratch. Many online platforms, mobile apps, software and hardware were invented during the hackthons. Hackathons may last a day, a week or any time in between.

Hackathons are forums for self-expression and creativity through technology. It’s good to have an open collaborative environment, but it also leads to exceedingly ambiguous situations, in which people don’t have understanding of who owns what or what rights and claims may emerge. Some precautionary legal measures can and should be taken during a hackathon to prevent unpleasant surprises. Some people are reluctant to ask their collaborators to sign legal agreements before anything is actually created because they are afraid to kill the camaraderie mood. In reality being straightforward about your goals and expectations never hurt anyone, but on the contrary, brought trust and respect.

There is no need to develop long complicated legal documents and have all involved parties study them for hours. Simple but properly implemented legal techniques can set the right tone and prevent small issues from spinning into huge, expensive battles down the road. A one-page collaboration agreement can address the main matters, such as

Do parties, who just met at the hackathon event, want to go into business together as partners if during this hackathon they create a product/service, which can be developed into a viable business?

If some do not want to get into a business partnership, do they agree to assign their interest in the developed intellectual property to others who may want to continue with its development?

Do they expect to be compensated for IP assignment? If yes, how the value will be determined? Payment terms? Will it be a lump sum or a payment plan?

The Shortest Agreement may look like this

This agreement is between Collaborator 1 and Collaborator 2. We agree as follows:

#
p<>{color:#000;}. Each of us, individually, is free to use any programming concept shared, discovered, or created during the Hackathon ______________.

***

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Startup Law

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  • Author: Kandy Bisht
  • Published: 2017-06-14 07:20:18
  • Words: 87427
Startup Law Startup Law