This Memorandum is subject to further review and update as circumstances develop and should not be relied on for any legal advice without consultation with an attorney.
Here are some questions founders should answer at this stage:
· What kind of company do you want to form and in what state?
· How will voting control be divided among the founders?
· How will the profits of the company be divided among the founders?
· Will the company offer equity incentives to its employees?
· Will the company seek outside investment?
1. Formation of your Company
First, you will want to determine what kind of company you want to form and in what state. Most founders of startup companies form either a limited liability company (LLC) or a corporation, both of which offer liability protection to the founders. LLCs can give founders (who are called the “members” of the LLC instead of “stockholders” as in a corporation) more control over how they run the company and divide profits, so LLCs can work well for single owners or a small group of owners who do not anticipate bringing in outside investors. The main advantage of LLCs is that they are “pass-through” entities, which means all profits are taxed once at the member level and not at the company level. Note that the setup, operating costs and complexity of LLCs can be greater in comparison to the formation of atypical corporation.
An alternative corporate form to an LLC that still provides pass-through taxation is an S-corporation. An S-corporation is limited to 100 stockholders, all of whom must be U.S. citizens or resident natural persons (stockholders cannot be other companies or entities, unlike in C-corporations and LLCs), and it must only have one class of stock. Outside investors often seek to own preferred shares of stock, so having one class of stock can be limiting when seeking outside investment. However, if the company plans to remain closely held with only a few individual person owners, an S-corporation can be a great arrangement. Additionally, if a company expects to have significant employee expenses, an S-corporation can offer tax advantages over an LLC. Here is a more detailed discussion on the different considerations between an LLC and an S-corporation.
If you intend to bring in outside investment to help grow your company, a Delaware corporation is most likely your best option. Delaware has the most robust corporate law framework in the United States and tends to be favorable to directors and companies. Delaware law is well understood and practiced by corporate legal and investment professionals, which means less cost to you in drafting, reviewing and negotiating legal rights and contracts. If you are looking for outside investment in your company from professional and/or institutional investors, they will likely expect that your company is a Delaware C-corporation. Instead of converting your company to a Delaware C-corporation at the time of a financing, you are much better off starting as a Delaware C-corporation to avoid the time and legal expense of converting. Be aware that unlike LLCs and S-Corporations, C-corporations are taxed twice – once at the corporate level and then again at the shareholder level.
It is important to note that the formation of your company in a certain state does not dictate where the company actually operates. You can (and many founders do) form your company in Delaware even if you don’t have any operations there. Once formed, a company will file simple foreign qualification forms in each of the states where it does business(“foreign” in this case means another state, not another country). The term “doing business” requires a complex analysis that is fact intensive so you should consult with legal counsel to determine in which states foreign qualification forms need to be filed.
In all cases, you should consult with tax and legal counsel to determine the best form of company and place of incorporation for your specific situation. Your legal counsel will put together a suite of legal documents that forms your company, issues equity to the founders, defines the voting control of the company and economic distribution to the founders, approves initial corporate actions, and prepares the company so that you can begin building that great product or service you have in mind. Once your company is formed, you’ll apply to the IRS for an employer identification number (EIN), open a company bank account, obtain any government permits that may be required for your business, and get to work!
2. Hire Employees and Consultants
Before you begin expanding your team, you want to make sure each person working for your company signs a non-disclosure/confidentiality agreement and invention assignment agreement before they begin work. Without these in place, employees and consultants have no legal obligation to hold in confidence company proprietary information, and the company will not acquire proper legal rights to the intellectual property that its service providers develop. Note that these agreements should also be signed by founders of the company, not just employees and consultants. While these forms are easy to implement upfront, the cost of not having them in place can be difficult and expensive to fix later so you should seek legal counsel to draft employee and consulting agreements that contain these provisions.
3. Establish an Equity Incentive Plan
If you plan to hire employees, do you want to pay them all cash or offer them a chance to share in the growth of your company as partial owners? Startup companies can often save some cash from wage and salary expenses by offering equity to their employees and consultants. This is typically done in the form of stock options of C-corporations, but can also be done via profits interests in LLCs. Profits interests are more complicated to set up and administer than stock options, but in either case you should consult with legal counsel to determine the best plan for your company and to have them prepare the proper documentation.
4. Seek Outside Investment
Once your company is off the ground, you may begin to think about bringing in outside investors to extend your cash runway. Investors will often expect many rights in exchange for their cash investment which include a seat on your board of directors, voting and approval rights on major company decisions, information rights to examine the company’s financial statements, and priority payment distribution rights on a sale transaction, along with several other secondary rights. Despite giving investors a seat at the table and an equity stake in your company, taking in outside investments can be appropriate if you have decided you want to grow faster than the pace at which bootstrapping often allows.
One major benefit to having professional investors as stakeholders is that they can provide a wealth of experience and access to their professional networks. In addition to the cash they provide, a good investor will be a valuable advisor to your company and can help guide founders to avoid approaching storms and navigate choppy waters. Not every investor may be a good fit for your company so you will want to seek investor-advisors who are going to be beneficial team members and not merely sources of capital.
5. A Warning about Term Sheets
The major business and legal points for important negotiations with investors, suppliers, significant customers, and other business partners often occurs at the term sheet stage. It can be very difficult to walk back unfavorable terms once a term sheet is signed. We strongly recommend founders consult with legal counsel before signing a term sheet so counsel can assist in negotiating favorable terms for the company and/or founders.
6. Conclusion
Getting your company formed and team assembled is the first step in turning your idea into a tangible product or service. It can be challenging to navigate the myriad decisions, but having a good legal team to guide your steps is invaluable to help you focus on the important matters and avoid some of the early pitfalls. Feinberg Hanson would be honored to partner with you on your journey to build your team and a successful business!