DROR FUTTERdfutter@sor inrand.com

JOSEPH FERINOj fer ino@sor inrand.com

© 2013 Sor inR and LLP, a l l r ights reserved

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Legal Issues for Start-Ups

Disclaimer2

This presentation and these materials are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. The opinions expressed in this presentation are those of the authors alone and may not reflect the opinions of the firm or any other attorney.

Choice of Entity3

Should I incorporate?When?Types

Corporation Limited liability company

Main issues Limitation of personal liability Tax Financing strategy Business management

Corporation?4

Separate legal entity governed by laws of its state of incorporation (usually Delaware)

Limits liability of its stockholders – generally, stockholders stand to lose only their investment amount and are not responsible for company debts

Easy to incentivize employees and service providers through options

Generally more tax-advantageous to incentivize employees through equity compensation than similar equity interests in an LLC

Double Taxation Corporate income taxed when received by the company and again when

(if) it is distributed to the stockholders S-Corporations eliminate this “double taxation,” but are subject to

specific stockholder eligibility requirements and limited number of stockholders

Limited Liability Company?5

Some of the same benefits as a corporation Limited liability of owners

More flexibility than a corporation in many respects Greater discretion with respect to distributions of profits,

management and allocation of profits and losses

A “pass through” entity (unless equity holders elect otherwise) Profits and losses flow to equity holders No double taxation Equity holders can take advantage of early losses

Choice of Entity6

Practical considerations Venture capital firms do not generally invest in

LLCs Most venture capital firms will require an LLC to

become a corporation prior to making an investment (this could add additional time and transaction cost to a financing)

Corporation makes equity incentives easier LLC may be more tax advantageous to founders

Ultimately, a fact-specific determination

Early Stage Financing7

Need for outside funding for operations, growthSources of financing

First outside dollars may come from friends and family or personal savings

For small financings, angels or friends and family might be a better option than institutional investors

Types of financing Could take many forms depending on the investor Straight debt, convertible debt or common equity

Venture capital investors Bring experience in your sector and contacts (more than just a

check) Preferred equity

What Should I Care About?8

Besides the amount of the check, what else should I care about?

Preferred Stock carries economic rights and preferences superior to Common Stock, along with certain control rights

Liquidation Preference9

Preferred stockholders receive a return on shares upon a “liquidation event”

Merger Sale of substantially all assets IPO

At least the value of their investment (possibly, plus accrued dividends) and/or a multiple (such as 2x or 3x), before common stockholders are paid

Preferred Stock is usually convertible at the holder’s option, so preferred stockholders get greater of (1) liquidation preference or (2) what they would receive as common stockholders

After the preferred stockholders are paid, the balance of proceeds is distributed:

To the common stockholders pro rata, or To the common and preferred stockholders together (“participating

preferred”)

Dividends10

Can be paid only “when, as and if” paid on the Common Stock (i.e., never)

Can be cumulative and paid upon liquidation or redemption (like interest) Guarantees a minimum return at the time of payment

Conversion to Common11

Preferred Stock converts into Common Stock (usually at, initially, a 1 to 1 basis)

Converts at option of the holder, by certain shareholder votes, or automatically, as upon IPO

Conversion ratio is adjustable Common Stock splits, similar events so Preferred Stock

retains value – no net economic effect Anti-dilution protection – protects against future stock

issuances at a lower price

Preferred Stockholder Rights12

Voting Rights Preferred stockholders typically get the right to approve major

corporate decisionsBoard Representation

Preferred stockholders typically get the right to appoint Board members and observers

Preemptive rights (right of first offer) Preferred stockholders have the right to participate in subsequent

equity issuances on a pro rata basisInformation rightsFounder restrictions

Right of first refusal on transfers Non-competition, non-solicitation agreements Company repurchase right on founder shares

Employment Issues

Employment Terms “At-Will Employment” Equity Grants Confidentiality Non-Competition Non-Solicitation Assignment of Intellectual Property

ConsultantsInterns

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At-Will Employment

Except for senior executives, in the US it is rare for a venture employee to have an employment agreement

Most employment is “at will,” which means either side can terminate the relationship for any reason at any time

Two weeks is a typical notice period, although longer periods are some times found for senior executives/critical employees

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Equity Grants

Employees are often granted equity interests in the company. 3 main forms: Stock Options Restricted Stock Grants Profits Interests (LLC)

Main terms: Strike price Vesting period Exercise period

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Other Employment Terms

Confidentiality Perpetual or term of employment plus a fixed period

Non-Competition Prevents employee from working for a competitor Courts will not enforce overly broad clauses and non-

compete clauses are not enforceable in California Typical limitations

Duration Geography Definition of competitor

Non-Solicitation Prevent former employee from “poaching” colleagues and/or

engaging former customers

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Assignment of Intellectual Property Rights

By “default” a company does not necessarily own all IP created by its employees Patents initially are owned by their inventors

Employees are required to assign all IP to their employer and agree to sign any documentation required to: transfer the IP file for registration of the IP (example: filing for a patent)

Issues to be addressed IP created after hours IP created using company assets, but not on company time IP unrelated to the business of the company

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Hiring Issues

Consultants – even though you call someone a consultant, the law and tax authorities may treat them as an employee (“Deemed Employment”). Misclassifying an employee as a consultant can have significant tax consequences

Unpaid Interns – a string of recent cases have made it clear that it is very difficult to hire unpaid interns if they are performing tasks similar to other paid employees and in the absence of an educational purpose. Among the consequences, many unpaid interns are working violation of minimum wage laws

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Intellectual Property

PatentsTrade secretsCopyrightsTrademarks/Service MarksTrade names

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Coverage

Patents – inventions that meet certain criteria including novelty, non-obviousness and utility

Trade secrets - secret processes, techniques and methods employed by a business

Copyrights – works of authorship such as books, music, software, photographs and paintings

Trademark/Service Mark – the words and/or graphics that a business uses to distinguish its products or services from those provided by another entity

Trade Names – corporate name of an entity

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Duration

Patents – 20 years from filingTrade secrets – for as long as the

confidentiality of the trade secret is maintained

Copyrights – life of the author plus 70 years, similarly long periods for corporate authors

Trademarks/Service Marks – with proper “policing,” potentially perpetual

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Copyrights

Copyrights Use of © in a circle does not require registration. Can

be used any time a work is created Format is © [Year] [Author]. All rights reserved If a work is updated, year should include initial year

and updates: © 2011, 2012 ABC Corp © 2011-2013 ABC Corp

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Trademarks

Common Law Trademarks Do not require registration Designated by ™ (product) or SM (service)

Registered Trademarks Can only be used for marks that have been approved for

registration by the Patent and Trademark Office Designated by ®

Trademark v. Trade Name One designates a brand. The other than name of a

company. Same phrase can be both. Example: Google today announced the launch of its Google

Lawyer™ product. First usage – trade name, second – trademark

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