Legal Issues for Start-Ups
Merrill M. Mason
December 2, 2010
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Steve Jobs, founder of Apple
and Pixar:
“The thing that drives me and my colleagues both at Apple and Pixar
is that you see something very compelling to you and you don’t quite
know how to get it, but you know, sometimes intuitively, it’s within
your grasp. And it’s worth years of your life to make it come into
existence.”
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
…and Then On the Other Hand…
“Starting companies are like having babies –
fun to conceive but hell to deliver.”
-- Anonymous
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Role of the Corporate Lawyer
Legal Advisor
Business Advisor
Value Adder
Voice of Reason
Introducer
Sounding Board
Confidant
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Issues During Start-Up Formation
Making Initial
Decisions
• Choice of Entity
• Incorporation
jurisdiction
Forming Legal
Entity
Planning for the
Future
• Founder’s Equity
Allocation
• Board
• Incorporation
• Tax Issues
• IP Assets
• Bylaws
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Choice of Entity
Considerations
C Corporation
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Continuity of existence
Ease of transfer of ownership
Easier to raise capital
Separate entity from owners
S Corporation
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Regular corporation meeting IRS test
Difficult choice for startups
LLC
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“Incorporated Partnership”
Tax issues in liquidity events
Flexibility in operating agreements
Limited
liability for
stockholders
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
State of Domicile
Delaware
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v.
Developed case law
Business-like attitude
Willingness of counsel to provide
opinions
Ease of governance
Other jurisdictions
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Differences on specific points of
law
Local allegiances
Administration issues
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Process of Incorporation
File Charter
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Corporate Name – Need for Distinction
Par Value of Stock – Significance
Initial Officers and Directors
Adopt Bylaws
Payment for Stock
Charter is a
public document
Follow up on
organizational matters
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Appoint Board
Issue stock
Foreign qualifications
Tax ID number
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Forming Legal Entity: The Bylaws
What are bylaws?
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Rules of governance “pulled” from state statutes
What do bylaws address?
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Officers, Directors – election, meetings, authority
Organization of Board – special committees
Stockholder meetings
What may be included?
(contract v. charter v. bylaws)
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Share transfer restrictions to control shareholder pool
Indemnification to protect Board members
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
A Critical Asset: The Board of
Directors
• Number
• Outside Directors
• Role/Level of Involvement
• Compensation
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Going Forward Issues
IP Assets
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Founders’ Equity
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Taxes
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Identification & Perfection of IP
Rights
Assembling management team –
identify needs – cash and equity
compensation
Allocation and vesting of Founders’
equity
Dilution v. protection of Founder
Interests
I.R.S. Section 83(b) Elections
Importance of Timing and
Consistency in Valuation of Stock
Avoiding Taxable Income
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Start-up Legal Mistakes - People
• Improper or non-existent non-compete and
invention assignment agreements.
• Employment agreements with out-of-market
terms for severance or other items.
• Inappropriate use of titles (too many VP’s who
aren’t really VP’s).
• Outrageous nepotism.
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Start-up Legal Mistakes - Capitalization
• Issuance of stock (as opposed to options) to non-founders.
• Establishing unreasonable valuations by selling small amounts
of equity at high prices.
• Having dozens of small investors.
• Selling preferred stock in small amounts resulting in rights and
preferences that need to be revoked when a venture round
comes together (and the preferred is converted to common).
• Not establishing an option pool.
• Running afoul of securities laws in issuing stock.
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Start-up Legal Mistakes – Corporate
Governance
• Not establishing a board of directors.
• Not having bylaws.
• Not taking minutes and recording them.
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Start-up Legal Mistakes - Customers
• License agreements with toxic terms (e.g. rights
to source code).
• Agreements to provide maintenance or other
services without getting paid.
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Start-up Legal Mistakes – Technology
and Intellectual Property
• Using open source code in a proprietary product
requiring it to also become open source.
• Poor or non-existent patent writing (and strategy).
• Failure to maintain patents.
• Failure to file international patents and maintain them.
• Poor license agreements for in-licensed technology.
• Out licenses with partners which give rights away
without compensation. (Selling the company w/out
selling it.)
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Start-Up Legal Mistakes - Other
• Privately held company bad habits on the
balance sheet (e.g. cars, planes, rental
property).
• Related party transactions for real estate or any
service.
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
Buzz Words
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S corp
C corp
Option pool
Founders
Vesting
Restricted Stock
Incorporation
Executive Summary
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Business Plan
Intellectual Property
Common Stock
Preferred Stock
83(b) Election
Dilution
In/Out License
Spin-Out
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. . . and Then What . . .
“Only one thing is certain about a new venture:
It’s going to turn out very different from its business plan.”
-- William Congolton, Venture Capitalist
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©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
www.smithlaw.com
©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.
www.smithlaw.com
©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.