Legal Stuff Entrepreneurs Should Know

Legal Stuff Every Entrepreneur Should Know

Benjamin M. Hron

McCarter & English, LLP

265 Franklin StreetBoston, MA 02110

[email protected]

@HronEsq

Overview

�Organization & Governance

�Equity & Capital Structures

�Valuation & Taxes

�Intellectual Property

�Employees & Contractors

�B2B Contracts

�Questions

Organization & Governance

Types of Legal Entities

�Partnership

�Limited Partnership

�Limited Liability Partnership

�Corporation

– C-Corporation

– S-Corporation

�Limited Liability Company

Types of Legal Entities

�Partnership

�Limited Partnership

�Limited Liability Partnership

�Corporation

– C-Corporation

– S-Corporation

�Limited Liability Company

Organization Documents

�Corporations

– Charter (aka Certificate/Articles of Incorporation)

�Filed with state to create corporation

�Defines types and amounts of equity authorized

�Establishes rights of each type of equity

– Bylaws

�Governance Structure

�Other mundane details (ex. fiscal year)

�Typically track corporate statute

Organization Documents

�Limited Liability Companies

– Charter (aka Certificate/Articles of Organization)

�Name and limited detail about entity

�No info about type or rights of equity

– Operating Agreement

�Defines types, amounts and rights of equity

�Governance structure

�Usually includes complex tax provisions

�Little mandated by statute, so lots of variation

Governance Structure

�Corporations

– Owners = Stockholders/Shareholders

– Stockholders elect Directors

– Directors appoint and oversee officers

– Officers run day-to-day operations

�Limited Liability Companies

– Owners = Members

– May be “managed” by Members or Managers

– May also have officers, but not required

Equity & Capital Structure

Corporations

�Stock

– Common: share of value of the company

�Sometimes subject to vesting (i.e. “restricted”)

– Preferred has special rights/privileges

�Options to purchase stock

– Incentive Stock Options (ISOs)

�Can only be issued to employees

�Preferred tax treatment if conditions are met

– Non-Qualified Stock Options (NQSOs)

Corporations

�Authorized, Issued and Outstanding Stock

– Authorized

�Set in corporation’s charter

�Total that can be issued without amending charter

�Fees typically increase with # of authorized shares

– Issued: shares corporation has sold/granted

– Outstanding: shares issued and not repurchased

– Authorized stock not outstanding has no rights

�Vested v. Exercisable Options

� Vested = all rights have matured

� Exercisable = able to be exercised for stock

LLCs

�Ownership Interests Generally

– Set in operating agreement, not charter

– No impact on state fees

– Can be unlimited

�Capital Interest v. Profits Interest

– Capital Interest: share of value of the company

– Profits Interest: share of profits from given date

�Used as incentive compensation

�Somewhat equivalent to options … but not really

Fully Diluted Capital

�Overall capital with claim on company’s assets

�Typically Includes:

– outstanding stock (as-if-converted to common)

– outstanding derivative securities (as-if-converted to common) (ex. options, warrants)

– shares underlying options reserved for issuance

�Does NOT include authorized shares of common stock not outstanding or reserved

�Broad v. Narrow


�Pop Quiz: What is FDC of company with…

– 1M shares of Common Stock outstanding

– 300K shares of Preferred Stock outstanding that convert to Common Stock 1:1

– Options to purchase 200K shares of Common Stock reserved for issuance, of which

� 100K options are outstanding, but not vested

� 50K are vested and exercisable

– $500K of convertible debt with a conversion cap of $5M


�Answer:

– Narrow FDC

� 1M Common + 300K Preferred + 50K options vested and exercisable = 1,350,000 Common

– Middle of the Road

� Add 100K options outstanding, but not vested and exercisable = 1,450,000 Common

– Broad

� Add 50K options reserved = 1,500,000 Common

– Very Broad

� Add Convertible Debt, but at what $?

Vesting

�Sets limitations on rights of stockholder:

– For period of time; or

– Until occurrence of specified event (milestone)

�Stock not yet vested can be repurchased …

– If stockholder’s service ends

– Upon occurrence of certain events (ex. acquisition)

�Vesting may accelerate upon

– Acquisition

– Termination of service in certain circumstances

Splitting Equity

�Even split usually isn’t the right answer

�Key factors to consider

– Time invested and commitment going forward

– Role in the company

– Contribution of IP, cash or other assets

�Require most/all founders’ equity to vest

– Time based: compensates for “time served”

– Milestone base: compensates for achieving goals

– Unvested equity is repurchased if founder leaves

�Split will usually change over time

Securities Laws

�Federal and State securities laws apply to every

offer and sale of securities

�Securities must be “registered” or the securities or transaction must be exempt from registration

�Details of exemption dictate how and to whom securities can be offered and sold

�Penalty for failure to comply: purchaser of securities has right to get their money back

Valuation & Taxes

How does valuation impact taxes?

�Recipient has taxable income on stock when issued = FMV – $ paid

�Options not taxed at grant if strike $ ≥ FMV

– ISOs must be granted at or above FMV

– NQSOs should be granted at or above FMV

�So options are the preferred form of equity incentive compensation

– Recipient not required to pay for stock until it appreciates

Examples

�Ex. 1: Founder A contributes $10K for 50%; Founder B contributes “sweat equity” for 50%

– Does Founder B have $10K of income?

�Ex. 2: Shortly after initial common stock issued to founders for $1 each, company raises $100K by selling 20% of common stock to investor

– Do founders have $400K tax liability?

�Ex. 3: Company raises $3M through sale of Preferred Stock at $2M pre-money

– What is strike price of options post-financing?

Intellectual Property

�Patents – cover inventions

�Copyrights – cover works of authorship, including software code

�Trademarks/Tradenames – cover identifying marks/names used in a trade or business

�Trade Secrets – cover proprietary information used in trade or business

Types of IP

�IP developed before organization of the company belongs to the creator if not assigned

�Contractors own their work product absent a “work for hire” agreement

�Employer owns work product of employees

�Require NDAs and Work-for-Hire agreements for

everyone

Securing IP

Employees & Contractors

Employees & Contractors

�Different federal and state tests

– MA test is very restrictive

– No contracting around law

�Employees must receive:

– minimum wage

– overtime pay

– workers comp

�Interns – nearly impossible to meet requirements

�Penalties are severe and enforcement authorities are “employee-friendly”

B2B Contracts

Key Elements

�Description of goods/services provided

�Timing on and conditions to payment

�Ownership of IP developed

�Non-competition, Non-solicitation

�Confidentiality

�Representations & Warranties

�Covenants

�Indemnification/Limits on Liability

�Choice of Law/Forum

Key Elements

�Description of goods/services provided

– Goods/Services should be clearly described

– Specify timing of delivery

– Set some sort of threshold for quality

– Provide for remedy if goods/services aren’t delivered or don’t meet specifications

Key Elements

�Timing on and conditions to payment

– If payment proceeds delivery, what is the remedy if goods/services are never delivered or don’t meet specifications?

– If delivery proceeds delivery, what is consequence for late payment?

Key Elements

�Ownership of IP developed

– If silent, party developing IP owns it.

– Jointly-owned IP may not be controlled by anyone

�Patents – any owner can deal with freely; NO “duty to account”

�Copyrights – any owner can deal with freely but there IS “duty to account”

Key Elements

�Non-competition, Non-solicitation

– Enforceability depends on scope

– Non-competes hard to enforce

�Illegal in some states

– Typically last 6-12 months after agreement ends

Key Elements

�Confidentiality

– Make sure description of what is covered includes any type of proprietary information your company is going to disclose

– Excluded from “Confidential Information”:

�Info in or that becomes part of the public domain

�Info received from 3rd party not under NDA

�Info independently developed by recipient

– Exception from non-disclosure obligation where compelled by law

Key Elements

�Representations & Warranties

– Statements of fact true as of the date made

– Bridge knowledge gap between parties

– Want other sides R&Ws to cover information material to your decision to enter into the agreement that is much easier for them to provide than for you to determine independently

�Ex. Entering into an agreement with you will not breach any of their other contractual obligations.

Key Elements

�Covenants

– Promises to do something in the future

– Be sure you can perform on your covenants

– Be sure the agreement includes necessary covenants for the other party

Key Elements

�Indemnification/Limits on Liability

– Indemnification is the right to have someone else make you whole for an injury

�Should be tailored to circumstances

�Very complex body of law

– Limits on Liability

�Typically eliminate liability for anything other than direct damages (i.e. no “indirect” damages)

�Usually excludes indemnification obligations and breaches of NDA or IP ownership obligations

�Mutual?

Key Elements

�Choice of Law/Forum

– Determines how agreement will be interpreted

– Determines where disputes will be settled

– Usually determined by relative bargaining power of parties

– Consider how choice of forum will impact your costs if you need to enforce the agreement

Questions?

Benjamin M. Hron

McCarter & English, LLP

265 Franklin StreetBoston, MA 02110

[email protected]

@HronEsq