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Ads! They’re everywhere. Why do so many companies promise to incorporate you instantly for just a few hundred bucks, when lawyers charge thousands? Way down in the fine print, these online outfits are careful to say that they aren’t lawyers and none of the services they provide qualify as professional legal services.
If you buy one of these online packages, what you essentially get is a filing service plus a boilerplate set of constitutional documents. I’d rate the filing service as worth maybe $20, since it saves you the trouble of going to your state’s website to download your state form and mail it in. The boilerplate documents, however, can be outright dangerous.
The documents you download from an online package have to be one-size-fits-all, and (much like a hospital gown) they really won’t cover you. Some of our clients come to us with these documents, and we have to re-do everything from scratch because:
1. The hospital gown document says nothing about how voting works within the company, or who signs corporate checks, or whether certain major actions (such as selling the company) require a supermajority vote.
2. The hospital gown document says nothing about vesting. Everyone just gets shares on Day 1, and the company has no buyback right at all.
3. The hospital gown document doesn’t try to keep the company closely held — shares can be transferred by anybody, to anybody, at any time, at any price. There’s no right-of-first-refusal process, so shares aren’t offered to existing shareholders first. In fact, there’s no obligation to even tell the other shareholders that shares are changing hands. There’s also no protection against court-mandated transfers in cases of divorce, which is a more frequent problem than most entrepreneurs realize.
These are just the biggest problems that jump out at me when I look at these docs. Good legal work is expensive, but bad legal work can be a hundred times more expensive. If you’re going to invest a lot of time in a new venture, invest in a solid legal foundation up front.
The ways of funding are as myriad as the ways of love, so let’s compare funding to marriage:
- You should know who you are before you get married. It’s possible to get funded too early, and the power dynamic will always be off kilter. We often advise entrepreneurs to get some traction (the more mature your company, the better your negotiation leverage) and/or have a clear idea of how they want to deploy new capital (make sure that your vision aligns with the investors’ vision).
- Some marriages don’t go so well. Money feels a lot like love, and it’s easy to make rash decisions while under the giddy spell of promised money.
- Some engagements will be broken. A termsheet is a serious sign of commitment, but most of the terms of the termsheet are not legally binding. There’s almost never a binding obligation for either party to complete the deal (or if there is, there will be out clauses big enough to drive a truck through). Confidentiality will be binding, and sometimes there will be a binding obligation for exclusive negotiations. For the most part, the termsheet governs the legal rights and obligations of the diligence period, and anything it says about a future deal is pure speculation. It’s a long way to the altar, folks. Enter an engagement in good faith, but keep your eyes open — some entrepreneurs have had to pass up better deals due to an exclusivity clause or revealed their competitive information only to be jilted after the “investor” decided to develop the technology in-house.
- Some people get more than they bargained for. There are plenty of deals where a 5% ownership stake controls the whole company, so read that fine print carefully. You might be surprised who wears the pants in the relationship.
- Four states still require blood tests for a marriage license. The business standard is to run a set of bankruptcy, judgment, and lien searches. You should get searches for both the corporate entity and the principal people (individually) who are about to become major players in your business. They are about to become your business partners, and you can bet they’re checking up on you.
- Successful marriages can be long, fruitful, and exhilarating. A partnership with a powerful investor can open up vistas of opportunity that your company would never be able to experience alone, so yes, despite all the caveats discussed here, funding can be a many-splendored thing.
6. Equity is a powerful tool, so deploy it with care.
Shareholders have a powerful slate of legal rights, including the right to see your company’s financial information and to sue the officers of the company. If things go run-of-the-mill badly, you could end up with underperforming deadweight on your team. If things go thermonuclear, you could end up with a shareholder who gives information to your competitors and brings lawsuits against you. Because the downsides are so severe, making someone a shareholder is a serious decision.
Granting equity makes a person your business partner. Equity should never be a quickie substitute for cash; it should be similar to partner track at a consultancy or tenure at a university. Like tenure, it’s rare for a shareholder to give up equity, and it’s virtually impossible to force them to leave. In most situations, if you want them out, you’ll have to buy them out at an exorbitant price.
Therefore, like tenure, equity should take time to attain. There are all kinds of ways to structure the incentives, both for LLCs and for corporations.
7. Keep everything in the name of the company.
Some people want to sell their startup to Apple and retire. Others want to build an empire and pass it on to their children. No one is planning on living forever and running their company 150 years from now.
To make sure your company has plenty of options in the future, keep everything in the name of the company. Here’s a quick test: Right this minute, is your company’s domain name registered to you personally, or to your company?
Here’s another test: Right this minute, if your contact at your biggest customer moves on to another position, will you still have that customer? People bounce from job to job these days, so we rely on contracts rather than handshakes. Handshakes can’t be sold to Apple or passed on to your kids.
The value of your company is in its assets and its contracts, not your assets or anybody’s handshakes, so go out there and actively create value in your company.
4. Develop good habits for your corporate bank account.
A business account isn’t just for taxes and housekeeping — it’s also of extreme legal importance. Mixing personal assets with business assets is a mortal sin, even if you are a one-person company. For example, if a customer pays with a check made out to your personal name, always take the extra 3 seconds to flip it over and sign it to your business account. Then deposit it into your business account.
Similarly, never charge personal expenses to your corporate debit card, even if you are the sole owner and it’s all your money in the end. Money should only come out of the company in the form of dividends and distributions to shareholders.
Why are these good habits so important? Because you must, must, MUST respect the boundary between personal assets and business assets. If you don’t respect that boundary, the court won’t either. Let’s say your company gets hit with a $20 million patent lawsuit. If the lawyers on the other side discover that your money trail isn’t tidy, there’s a very real risk that they can “pierce the corporate veil” and reach through the corporate liability shield to jeopardize your personal assets. Once your home and savings are on the line, you’ll be in a much worse position (both legally and emotionally) during settlement negotiations.
5. Don’t forget the corporate formalities.
From the law’s point of view, you must take your company seriously if you wish the court system to take your company seriously. To that end, your corporation should hold at least one meeting every year (LLCs are held to a lighter standard, which is one of the biggest benefits of choosing the LLC entity type). Anything less can weaken your liability shield.
A meeting doesn’t have to be complicated, and it doesn’t have to be in-person. Most “meetings” are actually done in writing. If you own a one-person company, for example, you can type up a simple document that says “Minutes of the company meeting for the year ending 2011″ and say that you have reviewed and approved the company’s 2011 financial statements, which are attached. These financial statements can be self-prepared, and they don’t need to be audited, since they are for internal use only.
The Washington Post did a great interview with us on things that every business owner should know. It was a pretty in-depth interview, and we’ve had such a positive response that we thought we should expand on it here on the blog. In the next few blog posts, we’ll cover all ten of our Top 10 Legal Tips. Here are the first three, which should sound familiar if you’ve been doing your homework.
1. Don’t stress too much about whether your new company is an LLC or a corporation.
The internet is full of chatter on LLCs versus C-Corps versus S-Corps, but by far the most important thing is to register a company – of any kind. Your choice is not set in stone. If you do change your mind, it’s typically easier to convert LLCs to corporations than the other way around.
As attorneys, we are constantly asked to weigh in on entity type because it’s often the first decision point that people reach, and first decisions tend to be the most intimidating. The simplest answer is:
- If you intend to seek institutional funding from a venture capital firm, you should be a Delaware S-Corp or C-Corp.
- If you are self-funded, talk to your personal accountant. Entity form is primarily tax-driven, so make a spreadsheet of base-case, best-case, and worst-case scenarios and ask your accountant what your taxes would be like in each scenario as your business grows over the next 5-10 years. The best choice for your specific situation will depend on many factors, including your personal tax bracket (from your other sources of income) and how much you plan to re-invest in your company.
2. A company isn’t just for branding or legitimacy – it’s also a liability shield.
Declaring corporate bankruptcy doesn’t affect your personal credit score, which makes setting up a company the best and cheapest “insurance” for your venture. In the United States, you can be sued for $50,000 just for using a photo without permission. You’ll sleep better knowing that your worst-case scenario is to dissolve your company and start a new one.
3. For many small, local businesses, Delaware is not the right choice.
There’s a persistent myth that incorporating in Delaware will save you taxes, but that’s simply not true. Just think: do you pay income tax based on where you were born, or where you currently live and work?
If you choose to incorporate in Delaware, you should be aware that you still have to register locally. For example, California charges an unusually high minimum franchise tax of $800 per year, whereas Delaware’s minimum is $75. A San Francisco company might be tempted to incorporate in Delaware in order to take advantage of the tax savings…except that it has to register in California after it incorporates. Therefore it gets to pay Delaware, and then pay California, and then pay its lawyers twice for doing duplicate paperwork.
The real reason to incorporate in Delaware is if you want to leave the door open for outside funding on a national level. National investors prefer Delaware companies because it’s easier for investors, lawyers, and accountants to familiarize themselves with Delaware’s rules, rather than learning 50 different sets of state rules. If you have real plans to take your company national, then Delaware is right for you. If you are a small business that won’t be taking outside investment, think local.
And yes, it is possible to incorporate elsewhere and convert to Delaware later.
Common Deadly Mistakes for Growing Businesses (a tax+legal workshop)
This hands-on workshop might be the most useful strategy session you do all year. Now that your business has taxable profits, learn the single most expensive tax mistake that business owners often make. For long-term planning, learn how to maximize your value in an exit, partial exit, or growth plan. Presented by Kim Bey, CPA, and Sue Wang, Esq., this session will highlight specific ways to avoid some of the most common pitfalls that a business can encounter. We’ll address relevant questions such as: Can a few targeted changes save you thousands in taxes? (Yes, if you’re smart.) Can you lose control if you sell only 10% of the company? (Yes, if you’re careless.) Can you dramatically reduce your tax audit risk? Can a “mileage allowance” mistake cost you thousands? Can you really get sued if you ask a job candidate if he has children? (Yes, yes, and yes.) With plenty of time for questions, this workshop will help you plan for years of healthy growth. This two-hour workshop is limited to 20 participants.
Top 10 Legal Tips for Starting a New Company
Our most popular legal talk! Come learn how to be smart about paying people with equity, how to plan for exit and growth, and how to finally get past the analysis paralysis of LLC/C-Corp/S-Corp decisions. We’ll share actionable advice on how to set up your company for maximum flexibility in the future. This will be a fast-paced presentation followed by plenty of time for questions and networking.
How to Get Paid
Experienced businesspeople know that doing the work and getting paid are two different things. Does your contract spell out the terms clearly and in your favor? This talk will focus on great ideas to bake into your deal up front, to avoid a big mess later. We’ll talk about scenarios that apply whether you are a developer, an ad-supported website, a customer-facing business, or even a landlord. This will be a fast-paced presentation followed by plenty of time for questions and networking.
Entrepreneurs are famous for loving risk, and lawyers are famous for hating risk. As entrepreneurial lawyers, where do we fit in?
I once explained to DC-area venture advisor Glen Hellman that we try to spot risks like a lawyer and deal with them like an entrepreneur. The best lawyers don’t just go around saying “no, no, no.” An excellent lawyer spots problems and then follows through by solving them.
“That sounds great,” Glen said, “but what would you advise Travis Kalanick of Uber?” Travis had mentioned onstage at Startup Mixology that he might be dragged off to jail shortly. Uber, a wildly popular private car service, has been operating without taxi permits in San Francisco and New York. Each violation could theoretically get Travis up to 60 days, and given Uber’s wild success, Travis is on his way to racking up a few centuries of jail time. What can a lawyer say to Travis, other than “stop breaking the law”?
Well, let’s break this problem down. If a business needs a particular license – whether for taxis, trademarks, software, or anything – and that license is hard to get, my first thought is to see if we can get a sublicense from any licenseholder. Bonus points if we can structure the payments so that our client doesn’t have to pay much up front. In this case, there are probably individual taxi drivers who wouldn’t mind some passive income, but this is probably the option that Uber has already looked at and priced out. Let’s move on.
Another workaround is to redefine what you’re doing. I’ve seen all sorts of businesses operating as “private clubs” where you join for free right when you walk in the door. Until a few years ago, this used to be a popular option in England, where the official cut-off time for serving alcohol was 11pm in “bars” but responsible adults could imbibe with less restraint in “private clubs.” Unfortunately for Uber, New York’s taxi officials are one step ahead on that one, so let’s keep brainstorming.
What if we completely redefined Uber not as a private car club, but as a car-pooling mechanism that involves cash exchanges only part of the time? For example, Zaarly (whose co-founder happens to be an attorney) creates location-based peer-to-peer markets. If you’re about to board a plane and really want a window seat, you open up Zaarly and offer a price. Anyone nearby on Zaarly can see that offer on that phone. In a total disruption scenario, Uber could create a Zaarly-like platform so that any member of the public could offer a ride, but only some drivers had Uber badges guaranteeing a certain level of quality. Would the city of San Francisco really tell its residents that they can’t offer a ride to another resident? If this type of ride is illegal, so are all carpools where gas money changes hands. This would be a fresh and interesting question of law, and by the time a policy solution is worked out (many years), Uber would have moved on to another business venture or been so successful at this one that it can buy all the taxi medallions it needs.
Alternatively, since mathematical modeling is their strong suit, Uber could look into dominating the dispatch side of the taxi business. There are plenty of moneymaking options other than a head-on brawl with the law. In a head-on collision, The Clash gave good legal advice when they sang, “I fought the law, and the law won.” (Al Capone –> imprisoned for income tax violations. Remember?)
So I was enjoying the Daft Punk soundtrack for TRON today, and there’s one niggling thing that’s been bothering me ever since I saw the movie last Christmas. I’m about to reveal myself as a super-nerd, but seriously, what will happen if people rely on movies for legal advice?
In the opening scene, Young Flynn infiltrates his own company and releases the software as open-source. He gets chased down by an unexpectedly intrepid security guard who goes beyond the call of duty and follows Flynn out to the end of a construction crane. (That’s your first hint that we are far from reality.)
Teetering on the crane, Young Flynn explains, “Don’t worry, your boss approves of what I just did.” He explains that the guard’s boss is ultimately the CEO, and the CEO’s boss is the shareholders, and Flynn is the biggest shareholder.
Therefore, Flynn can give the software away for free?
WRONG! SO SO SO WRONG!!! All the Daft Punk in the world won’t make this right!
Flynn may be a genius hacker, but he fails Corporate Law 101. If the first principle of geometry is that the shortest distance between two points is a straight line, and the first principle of physics is that energy can’t be created or destroyed, the first principle of corporate law is that companies belong to shareholders. All of the shareholders, not just the majority shareholder.
Here’s a thought experiment: Suppose I give my niece and nephew a car. I give it 95% to the older one and 5% to the younger one. Can the older one donate the engine to the kidney foundation?
No way, Flynn. It doesn’t matter if you own 51% or 99.99%. If there’s one minority shareholder out there, you’re getting sued.
I like the garage doors in your bachelor pad, though.
The older I get, the more fun it is to hang out with young folks and soak up their life force. I spent last Saturday mentoring at Startup Scramble, a very high-energy event with students from GW, Georgetown, American University, and several other DC colleges. Our mission: to launch a venture in a weekend (much like Startup Weekend), but with a special emphasis on the triple bottom line.
People in all stages of their careers have asked me about non-profit projects, and specifically what it means to be a 501(c)(3) org. Here, for the edification of the whole internet, is a rundown of the pros and cons of being a 501(c)(3).
We played some lively rounds of Family Feud to brainstorm the concepts, and I was amazed. These students knew everything. Internet + free time = omniscience + YouTube.