On Thursday, October 25, 2012, OLC attended NYTech Council's Legal Essentials for Startups: Part 1 of 3: Organizing the Entity, at Anchin. Three panelists were present—Frode Jensen, Partner at Holland & Knight LLP; Glen K. Westerback, Associate at Frankfurt Kurnit Klein & Selz; and Paul Ellis, Principal at Paul Ellis Law Group LLC.
Paul Ellis started as the moderator, but he turned the presentation over to Frode Jensen. Jensen gave a brief background on Holland & Knight, calling the firm, "one of the largest in the world."
Jensen first described the preliminary considerations of starting a startup. "Where do you start the company?" he asked. If an idea has a commercial application, if it produces something or provides a service that can be traded be money, the "possessor of the idea" must consider five things. 1) Does the idea belong to someone else? 2) Is the possessor of the idea subject to an employment agreement (which gives intellectual rights to the employer)? 3) Is the idea subject to a patent, trademark or copyright? 4) Is there a restriction clause in the employment contract (non-competition agreement)? 5) Are soliciting colleagues to become partners restricted (non-solicitation agreement)?
The lifespan of a business is a cycle. Jensen demonstrated that it all starts with an idea. It moves to the organization of a startup, then to the execution of an idea (building prototypes), the implementation of strategy (revenue stage), optimize potential, and then the exit strategy. It repeats soon after.
"It's hard to write a black rule of thumb, but if you're thinking of organizing an entity, the following circumstances can be triggers," Jensen said. "The founder begins to spend more than a trivial amount of money on the startup or the possibility of commercialization of the idea becomes possible," he said.
Starting the startup early than late was the overall consensus between the panelists. "In a competitive industry, the startup may lose first-mover advantages if they wait too long," Jensen said. "Many founders wait formally to incorporate. Liabilities arising before incorporation generally cannot be ceased by subsequent incorporation." Paul Ellis took the opportunity to emphasize Jensen's point. "Problems among co-founders can lead to failure. Sometimes, they can't sort it out and it leads to the company becoming dissolved." During the idea stage, Jensen suggested that the founder and co-founders talk about percent ownership. "It's a very sensitive issue, but it has to be talked about and documented," he said. If there is no documentation to clear up positions regarding the company and differences arise, discussions move from difficult to impossible.
Startups can take four paths into structuring their business: 1) Sole Proprietorships, 2) Partnerships, 3) Limited Liability Corp., and 4) Corporation. The optimal business structure depends on circumstances of founders, business plan and the entity itself. Jensen gave reasons to form and organize an entity. "You get to limit liabilities—protect personal assets," he said. "Corporations and LLCs are marvelous inventions of modern legislations to promote business with limited liability." It also provides accounting clarity, tax minimization and flexibility, external funding, gives credibility, enhances protection of intellectual property and accommodates employees. As an aside, Jensen said, "It's very important to get your books set up." He revealed that courting accountants early on will be extremely beneficial to startups.
Sole proprietorships are individuals who own a business by themselves, and are not considered an entity. "There is one owner, which is an inappropriate form for a business. A business has multiple founders, investors and partners to help steer the business for maximum profit," Jensen said. Sole proprietorships, however, are easy to set up. The owner and the sole proprietorship are taxed as one entity for tax purposes and it cannot be sold off as an entity.
A partnership is a business organization in which two or more individuals manage and operate a business. There are two types of partnerships: General and Limited. A General Partnership means partners have unlimited liability. Limited Partnerships mean that general partners have unlimited liabilities and limited partners have limited liabilities. Limited Partnerships have limited liability characteristics and pass-through tax treatment. "You don't want to be a general partner," Jensen joked.
Limited Liability Corporations have all of the benefits of corporations minus the rigidity of a corporation. A major problem with LLCs is that is has "so much flexibility that startups can get bogged down." LLCs "are not a corporation," Jensen said, "it is a company. It is a creature of the law." LLCs provide limited liability and pass-through tax treatment, which can be elected away. LLCs, however, are somewhat disfavored by VCs and offshore investors—VCs and offshore investors prefer Corporations because it is tougher to use a preferred stock structure in LLCs. Its main flexibility is that ownership can be sliced and diced to benefit members disproportionately.
LLCs are formed by submitting articles of organizations to appropriate state authorities. Members have no personal liability aside from the value of equity contribution. Profits can be divided up among the members. "LLCs are increasingly common between startups," Glen Westerback said.
"Converting to an LLC to a corporation can be relatively easy. It can be done. You can go the other way, but there are significant tax implications when doing that," Ellis said.
New York City's unincorporated business tax is one major drawback to LLCs. It is a 4% taxable income allotted to NYC and LLCs are subject to this tax.
A corporation is a separate legal entity with limited liability. There are two types of corporations: C Corp—taxable—and S Corp—pass-through—which can be seen as a hybrid between Partnerships and C Corps.
Optimal business structure depends on specific circumstances for the founders, business plan and the entity itself. "If a business is ready to attract venture capitalists or such, funding an anticipated incorporation like a C Corp is generally thought to be profitable," Jensen said.
Startups can be organized in any of the 50 US states. Any state of organization can be chosen. Many states however require that an entity pay additional fees when operating in another state. Jensen laid some considerations out when choosing a state to operate in. 1) Incorporation fees and taxes. 2) Level of corporation service. 3) predictability, developed case law and frequent updating of corporation statutes.
To re-emphasize the importance of communication between founders and co-founders, Jensen said, "Founders should confront and decide certain structuring issues at the time of entity formation." Names, classes of stock, composition of board, stockholder and board voting requirements, and titles and identities of officers should be established and conferred between the founders and co-founders.
Regarding governance and transfer issues, if there is more than one founder, these issues must absolutely be discussed and decided upon as soon as possible. Voting rights and vetoes, tiebreakers, buy-sell or the impasse provisions, transfer restrictions and exit rights (drag along and tag along) should all be covered in agreements.
"One of the biggest problems a startup will face is when they fail to sort out governance in the beginning have huge problems. Companies usually don't survive if they don't sort it out. No proper agreement means no effective way of agreement. From there, they have two options: negotiate, or dissolve. Most of them dissolve the company," said Ellis.
A deadlock problem arises when directors or stockholders cannot resolve an impasse. This happens when there is an evenly divided board or a tie vote among stockholders. There is no easy way to avoid deadlocks unless there is a set of procedures set up in advance to deal with the problem. Some ways are: uneven number of directors, buy-sell provisions, mediation or arbitration. "It is important to adopt deadlock-breaking procedures early on," Jensen said. "It's nearly impossible to adopt once a conflict has arisen."
The United States has tough securities laws applicable to all sales of stock and other securities. As a general rule, Jensen said, "No stock can be offered or sold unless registered or exempt from registration." Breaking this rule results in severe penalties. He suggested consulting a lawyer before offering stock.