This post outlines several startup law basics and tips for being due diligence ready. This is a useful topic because companies at any stage will benefit from careful planning and early organization. Simply put, begin with the end in mind. Attention should be paid to the following key areas: Incorporation, Accounting, Founders and Employees, Contracts, and Intellectual Property.
Receiving a term sheet for funding or finding a suitable buyer for exit are exciting events for entrepreneurs. However, transactions too frequently become over complicated by businesses not prepared with the legal and business information needed to close a transaction. The problem is that founders are rightly product and revenue focused, but financing or sale transactions require due diligence. Fortunately, entrepreneurs can have the answers to the diligence test before the questions are asked.
1. Incorporation.
The diligence process requires a company to provide evidence of its corporate structure and internal guidelines (operating agreement or bylaws depending on entity selection). Entrepreneurs should know that a sole proprietorship or general partnership can be created without any formal agreement or filing with the state. Do not wait too long before incorporating because neither the sole proprietorship nor general partnership model provide limited liability protection. A good rule of thumb is that once your idea and activities go beyond a hobby, then select and file the appropriate entity. This decision requires a choice on both entity type and filing location because incorporation occurs at the state level.
An LLC can be a great starting place depending on individual tax circumstances and business model, but a corporation is often the better fit for entities that plan to seek outside funding, scale, and give away equity. Regarding state of incorporation, it is usually best to select whichever state the company operates in or Delaware if there are plans to work with sophisticated investors. Fortunately, Colorado’s online Secretary of State website makes handling business filings very convenient compared to other states and Delaware has options for near immediate response time.
2. Accounting.
The diligence process requires analysis of a company’s financial and business records. Early stage financial projections are almost always wrong, but it is still good practice to hire outside help to keep organized from the beginning. Proper counsel can ensure that local, state, and federal taxes are accurately paid, loans (especially from founders) to the company are properly documented, financial statements are accurate, and appropriate methods are in place to track accounts payable and receivable. Plus, a well maintained capitalization table demonstrates savvy. As operations progress, an entrepreneur should be careful not to jeopardize limited liability protection by commingling company and personal funds. A classic commingling example is buying groceries on the company card.
The entrepreneur should be aware of two, federal tax provisions that can come into play early in a company’s development: 83(b) and 409A. 83(b) impacts capital gains treatment of transferred property that vests over time – think stock vesting. It might seem confusing to file an 83(b) when vesting stock is granted at incorporation, valued at $0.00001 per share and a transaction is far from the horizon, but making the election is simple and can result in significant tax savings. Most importantly, the 83(b) form must be filed within 30 days of receiving the property. Section 409A requires that stock options given to employees be at fair market value. This provision ties back into incorporation because incorporating too late and issuing inexpensive stock to founders while selling much more expensive stock to investors can raise questions with the IRS about the stock’s fair market value.
3. Founders, Employees and Equity.
The diligence process requires review of employment and equity agreements. Entrepreneurs should know that hiring and retaining talented workers is critical to success and that equity can be valuable in attracting such talent. The relationship between company and worker is governed by federal, state, and common-law requirements. A company must be careful in classifying a worker as an employee or independent contractor. Classifying a worker as an independent contractor can save considerable money, but improper classification results in legal problems and tax penalties. Proper classification depends on a fact-based inquiry guided by an IRS list of 20 factors. A well-written independent contractor agreement is a wise starting place and workers that are employees should be clearly designated as at-will.
Regarding equity grants, the entrepreneur should set expectations upfront in written agreements that define what will happen with unvested stock if a worker quits or is terminated or a business transaction closes. A simple Restricted Stock Purchase Agreement between the company and all founders, workers, and advisors can save time and money. Right now, it is common for founders and workers to see monthly vesting over a four-year period subject to a one-year cliff. Decisions about vesting should be given serious consideration because vesting is a useful tool for protecting the company and motivating workers.
4. Contracts.
The diligence process requires review of a company’s contracts to understand key relationships and obtain necessary assignments, waivers, and consents. A company should keep track of agreements regarding creditors, vendors, real estate, workers, and investments so that it is clear who is owed what.
A contract is a legally enforceable promise or set of promises and entrepreneurs should know that an agreement does not need to be drafted by a lawyer or contain fancy words like “whereas” or “witnesseth” for a court to enforce it. Courts have enforced napkin, instant messenger, and oral agreements. With this in mind, exercise care in making any type of offer. Well-written contracts accurately reflect negotiated solutions and set the rights, restrictions, and expectations of the parties – they are future oriented and help both parties understand what is to come.
5. Intellectual Property.
The diligence process requires review of a company’s intellectual property. All companies are IP companies in some form, and, for most, the majority of their value rests in their Intellectual Property. IP value can be found in trade secret protection of internal processes or customized software, trademark of a logo or brand, or patent of a novel idea or invention. Entrepreneurs should know that if they are currently working for a company, particularly as a key employee, moonlighting can cause IP problems and they should not operate a competing business.
In early stage companies, IP should be viewed more broadly than just code or technical contributions. Entrepreneurs should avoid infringing other’s IP, be vigilant in protecting new IP, and require founders and workers to sign a Confidentiality Agreement and IP Assignment to ensure that the company owns the IP. This agreement can protect against a situation where a company is gaining traction only to become embattled with someone claiming they own part of the IP - think Facebook or Snapchat litigation. Plus, a typical representation that a company must make to close a transaction surrounds ownership of IP.
6. Bottom Line.
Founders are rightly product focused because even the best organized business will not be around long without a quality product or service, but the entrepreneur can take incremental steps from the beginning. Early organization will keep due diligence from feeling overwhelming, result in lower legal costs and quicker closes, and demonstrate that you are a professional who understands what it takes to run a business. Conversely, if a company is not due diligence ready, deal momentum slows, legal fees rise, and ultimately deals can be killed. Entrepreneurs should begin with the end in mind because significant legal and business information will need to be disclosed in a business transaction.
I recommend two resources to explore these topics in greater depth: The Entrepreneur’s Guide To Business Law & Venture Deals.
Joel Jacobson is an associate attorney with RUBICON Law Group, Ltd. He practices business law, including formation, contracts, transactions, and securities and enjoys the opportunities it provides to work with innovative companies throughout the United States. He received his undergraduate degree from the University of Michigan and his law degree from the University of Wisconsin Law School. Joel has an interest in topics impacting the Colorado entrepreneurial community, skiing, and hiking. He can be reached on Twitter, LinkedIn, or Google Hangout.
Obligatory Disclaimer: This document is for informational purposes and is not legal advice. Your receipt of this document does not create an attorney-client relationship. You should not rely upon this information for any purpose without seeking legal advice from a licensed attorney in your state. We expressly disclaim all liability with respect to actions taken or not taken based on any or all the contents of this document. It’s a risky world we live in; I warned you.
