Part 5: Key Legal Questions to Consider when Starting and Growing a Tech Business March 22nd, 2012MMM Tech Perspectives by John Yates What are the Top 10 legal questions to consider in starting and growing a tech business? Outlined below are questions 5 & 6 in this series of questions a lawyer asks an entrepreneur to minimize liability and maximize profitability (view questions 1-4 here). These questions address legal issues faced by tech companies through the business life cycle. While these questions may not apply to all companies, they’re a helpful road map to address legal pitfalls in building a successful tech business. Following the questions below, there are secondary questions designed to elicit important information from the entrepreneur. Then, the legal conclusion and practical pointers are included. As referenced below, the new venture to be formed by the entrepreneur is Newco and the current (and soon to be former) employer of the entrepreneur is Employer. Q5: How should Newco be organized? What form of legal entity should be created by the entrepreneur/client? When should it be established and in what state? The structure, organization and time of creation of Newco are important considerations in the success of the new venture. Important questions to be considered are: A. Should the entrepreneur avoid incorporating or establishing Newco until after departure from the current Employer? B. How soon after formation of the legal entity will the entrepreneur desire to raise institutional venture capital? If the answer is very soon, then a C corporation may be the preferred legal entity to be created from inception. C. When would a limited liability company be the preferred form of legal entity? If the entrepreneur will only be seeking angel or individual investors, then a limited liability company may be the preferred legal entity for Newco, especially for purposes of passing on tax losses to investors, subject to tax limitations. D. Would an S corporation be a preferred legal entity under any circumstances? Generally, a limited liability company provides greater flexibility and does not have the limitations under the tax code for an S corporation. E. Is Delaware the preferred state of incorporation for Newco? Generally, venture firms will request that the company be incorporated in Delaware given the familiarity of venture funds and their legal counsel with the laws in that state. F. Can venture firms be convinced to invest in a Georgia corporation? Yes, in certain instances venture firms will permit the legal entity to be incorporated in Georgia. However, if Newco obtains additional rounds of financing, future venture capitalists may insist on reincorporation in Delaware. G. Are there any disadvantages to incorporating in Delaware? For example, how significant is the annual franchise tax in Delaware versus the annual report fee in other states such as Georgia? Answer: If the entrepreneur is very likely to raise institutional financing or venture capital in a short period of time after company formation, then a Delaware C corporation may be the most cost effective legal entity to be created for Newco. There are additional costs associated with a Delaware corporation, including the annual franchise fee which is generally much higher than the annual report fee in other states. Additionally, there may be need for Delaware legal counsel to render opinions with regard to Delaware law matters, adding costs to the Newco budget. In several cases, venture capitalists have agreed to allow Newcos to be established as Georgia corporations (rather than a Delaware entity), but future rounds of financing may result in the prospective investors requiring a reincorporation in Delaware. The time of incorporation of Newco can be important for reasons of protecting the entrepreneur from legal action by the former employer. The prudent course of action would be to wait for the entrepreneur to leave the Employer’s employment before establishing a new legal entity. Since the establishment of Newco — either as a corporation or limited liability company — creates a public record, premature company formation could be harmful to the entrepreneur precipitating future legal action by a former Employer that may assert breaches of legal rights by the entrepreneur. Q6: How should stock/equity and options/interests be allocated among founders and future executives/employees? This becomes one of the most important questions in attracting, retaining and motivating executive talent and founders of a new company. A general rule adopted by many seasoned entrepreneurs is to be stingy in allocating vested equity to others but generous in rewarding equity based on performance and meeting milestones. The key questions to be considered include: A. How many rounds of financing will the company generally need in order to reach profitability? This becomes an important consideration in determining how much equity will be remaining for the executive team and employees following the capital raising process. B. What are the expectations of the founders with regard to the return on their sweat equity investment — in other words, what do they expect their net worth to be when the company reaches the time of a liquidity event? The founders need to take into consideration the amount of outside capital to be raised, liquidity preferences (preferred investors who will receive the first return on their investment), and forecasted allocation of equity to other executives/employees to determine the expected equity that will remain with the founders on a liquidity event. C. How can the founders create an option/restricted stock “budget?” This generally requires a determination of the projected hiring plans and needs of the company in the next 12-18 months, the specific titles/positions of the “projected” new hires, and the anticipated amount of equity that would be required to attract and retain them. This “budget” is critical to determining the amount of equity to be reserved in the stock/option plan of the company available for grant/issuance to employees and executives. D. What input do the venture capitalists and outside investors have with regard to the allocation of equity among members of the executive team and employee base? E. What types of performance criteria and milestones are usually associated with the grant of options or restricted stock to executives, how are they measured, and how can they be used to motivate employees/executives? F. If repurchase provisions are included whereby a terminated executive/employee’s equity can be repurchased by Newco, what are the standard terms of repurchase? What is the price for the repurchase (fair market value of the equity at the time of repurchase or the price paid by the executive/employee for the equity)? G. For a company that has raised outside capital and has a significant liquidation overhang (that is, Newco must be sold for a high valuation before the common holders receive any return), how can a Transaction Bonus Plan be structured to allow executives to receive some payment on a liquidity event (since their equity will otherwise be worthless)? Answer: The entrepreneurial founder should consider issues of equity ownership at multiple stages of the company’s growth — start up, first round financing, later rounds of financing, and the ultimate liquidity event (a sale or public offering). The founding entrepreneur should determine the desired return on investment at a liquidity event and then structure the equity ownership accordingly. Often, venture capital firms will require a specific allocation of equity to current executives and future hires, requiring the company to maintain an option/equity “budget” for future executives. Additionally, the option/equity “budget” will be the basis for reserving a specified number of shares in Newco’s option/stock plan. Also, the option/stock arrangements with executives should generally provide for a repurchase of equity upon termination of the executive/employee. Frequently, the purchase price for repurchasing the equity will be the fair market value on the date of termination (if termination is without cause) or the price paid by the executive/employee (if termination is voluntary or “with cause” as defined in the employment agreement). *********** This information is presented for educational purposes and is not intended to constitute legal advice. Opinions expressed are those of the author and not of Morris, Manning & Martin, LLP; see our disclaimer for more information.