Startup Legal Issues

If you are organizing your startup in sunny South Florida, congratulations!

South Florida has in the past three years developed an emerging tech ecosystem with a strong gateway to Latin America and the U.S. Hispanic market.

This article’s goal is to support your launch by helping you avoid common legal and tax pitfalls as you launch your business – and to assure your company remains “fundable” by investors – in an efficient manner that will save you time, money and headaches down the road.
However, there are some fundamental issues that if dealt with in advance, will prepare you for your future Convertible Note, SAFE, Series Seed or Series A round, and avoid significant, potentially existential issues down the road issues that may cause financing sources to pass on your company and/or trigger major liabilities and tax bills. The points listed below should be addressed at the
beginning of operations (or as early as possible) for a new startup.

Legal Structure

Analyzing the best legal structure for your company is an important first step. The legal structure should be vetted by your legal, accounting and business advisers.
Common advice is that all new ventures should be organized as a C-Corporation in Delaware. Outside the startup world, most new ventures avoid C-Corp. status and the resulting “double taxation”, and while the CCorp. is still often the right choice for a startup, we recommend considering alternatives. This raises special issues and certain opportunities, and such companies should consider using an international holding structure for instance, with an offshore holding company, particularly if the company’s operations primarily are outside the United States. Please take a look at my prior
article on the subject of structuring alternatives:

http://privateadvising.com/three-structuring-options-forreorganizing-your-latin-america-startup-in-the-u-s/

For example, it is often beneficial to form as an LLC and avoid income tax. At some point, your investors may require a conversion to a C-Corp. That’s fine, and usually cheap and easy to accomplish (and we’ve done this several times). Switching out of the C-Corp. structure; however, is often costly or impossible.

Most startups exit through an M&A transaction, not an IPO – and in that case, you may be very sorry that you organized as a C-Corp.
The structuring analysis should consider the legal jurisdictions in which your organization will operate,
where its shareholders will be located, and the resulting legal and tax consequences.

“Florida is a low tax environment with a relatively simple regulatory environment.”

One of the benefits of operating in Florida is that Florida is low tax environment with a relatively simple
regulatory environment, especially as compared to California and Latin American jurisdictions. Please note that security filings (U.S. “blue sky”) are required when “The goal of this article is to help you avoid common legal and tax pitfalls as you launch your business.” an investor from a certain jurisdiction invests in your company. Florida’s exemption is “self-executing”, so no filing is required in connection with your 506 offering to Florida residents, but do make sure to provide the notice required by FL Statute 517.061 when selling to five or more Florida residents.

Many Latin American jurisdictions require the registration of its foreign shareholders i.e., the U.S.
holding company. Your eventual plans for profitability, distributions and exits should be discussed. For example, paying dividends, or being profitable within the first few years, is unusual for a venture backed company and will influence the legal and tax analysis.

Initial Organizational Documents

Once you’ve chosen your legal structure, your organization will need to prepare the initial formation
documents for the company. The goal is to keep these documents simple prior to your first financing round and ensure that the books and records are sufficient to support your Capitalization Table.

If you are starting a Corporation, you will need the following documents:

• Certificates/Articles of Incorporation
• Bylaws
• Organizational Resolutions
• Founder Stock Repurchase Agreement (vesting)
• Simple qualification (the requirement to qualify to do business in states/jurisdictions in which
you operates (e.g., a Delaware corporation operating in Florida))

If you wish to launch an LLC, the following documents are required:

• Certificate/Articles of Formation
• Initial LLC Agreement
• Founder Vesting Agreement
• Foreign qualification

You will also need to determine whether there will be an Incentive Plan and whether stock grants will be made per individual agreement. If grants will be made to a few employees, we generally recommend a simple grant agreement. Note that grant awards are more complicated and structured differently for an LLC (i.e., through profits interests).

Determining what company operates is also a key step. The legal entities may need to qualify to do business in other state and foreign jurisdictions. Note that if you are using a foreign holding company structure and the organization already has operations in other jurisdictions, we generally recommend an Exchange Agreement (Permuta), exchanging the shares of the operating companies for shares in the holding company.

Additionally you will need to:

• File for a Tax ID number (form SS-4) (may or may not apply to non-U.S. entities)

• File a “check the box” election in certain circumstances (especially if your organization
forms outside the U.S.) (Form 8832)

• Setup your bank account. This can be problematic if the founders are not U.S. citizens
and none have a U.S. social security number or tax ID. Please keep in mind that every bank has
its own know your customer, compliance and other requirements for account opening. Please
speak to several banks to determine which best fits your needs.

“Customer and compliance policies vary by bank. When setting up a bank account, it’s important to find the institution that best fits your needs.”

Nearly all investors will require the founder equity to vest over time. Two to four years is typical, but this will depend on several factors. There could be a reduction for “time served”, and it may be worthwhile to enter into a vesting agreement and begin vesting early on in the company’s history before a financing round – if your equity is already subject to vesting, the investor may just leave well alone and permit the founder’s equity to vest on the current vesting schedule (or at least permit a reduced vesting schedule).

Please speak immediately to a U.S. accountant when granting equity to the founders, employees or anyone else. A Form 83(b) filing may be beneficial and this filing is due within 30 days following the grant of the shares. Always ensure to properly document the fair market value of the company at the time of the grant of any stock/incentive awards.

At a certain point in your company’s growth, you will want to obtain a 409A valuation to add certainty that the IRS will respect your company valuation. Note that if a founder or employee resigns or is terminated (and especially if equity has been granted), a separation agreement will help protect the company. It is also a good idea to consider a non-compete, even preinvestment. It can be very damaging to the company if a founder sets up a competing venture. Equity paid for by the founders at fair market value should not be subject to vesting. Make sure to highlight this to investors.

“Software like eShares or CapShare will help get the company organized and into a much better position for investor due diligence.”

The company may want to setup an equity incentive pool -although there are reasons to wait until significant funding has occurred create a plan. However, whether the equity is granted under a plan or individual awards, make sure to grant the equity as quickly as possible; hopefully the startup will appreciate, and delaying award grants may trigger higher taxes to your employees (the tax owed is tied to the fair market value of the shares, and close to or after an equity round, and as the company’s IP appreciates, the fair market value of the shares likely will increase).

The number, class, series and percentage of shares held by each shareholder should be well documented and the capitalization table should make it easy for investors to understand the company’s capitalization structure.

A great idea is to use software to manage your capitalization table (like eShares or CapShare), especially
for companies with a large number of shareholders (a common issue in South Florida, where the investor check size is often $50,000 or less). There will be some upfront work to onboard your company to the management software, but the process actually helps to get the company organized and into a much better position for investor due diligence.

A startup often forms an advisory board to encourage experienced investors to advise the company on strategic issues, champion the company and make introductions to potential business partners and investors. This usually is not a true “board”, but a series of individuals given equity to assist the company – 0.25%-2% equity for each advisory board member is typical (with most in the 0.5%- 1% range). Note that investors in a financing round may desire a better deal/valuation than other investors (investors all feel they add special value), and advisory shares are often the best method to offer a better deal
without negatively affecting the valuation.

Intellectual Property Issues

Have all employees/consultants, especially anyone who has developed any code or designed the website or product, signed a confidential information and inventions assignment agreement. This is a key protection for the company to ensure it owns the intellectual property created by its employees and consultants. It is also a requirement of nearly all investors that all current and former employees and consultants have signed such an agreement.

“All employees and consultants should sign a confidential information and inventions assignment agreement.”

Keep in mind that success brings new challenges, including that someone with minor early involvement in your company will materialize seeking a payout. Note that potential business partners should sign a nondisclosure agreement to protect your IP. It is helpful that potential investors sign a non-disclosure agreement as well, but many will not do so (based on the argument that there are many similar projects that serial investors/VC firms consider on a daily basis).

All assets and IP should be held in the name of one of the organization’s legal entities (including domain names, trademarks, and patents), and not in the name of a founder. Which entity should hold the IP should be discussed with your accountant. There may be tax benefits to a non-U.S. entity owning the IP.

The company should register its trademarks. The more unique the mark, the easier to protect. Registration of a trademark in the U.S. will include a search to check that there is not another mark that is too similar. In the U.S., trademark protection is based on first use rather than first registration, making the search for prior similar marks quite important. Outside the U.S., the “Madrid” system
is a good method to obtain protection in dozens of countries via a single filing.

A patent must be filed within one year from any public use of the invention in the United States (e.g.,
commercialization) or any description of the invention in a published document.

The company will want to develop a data privacy plan that complies with federal, state and foreign requirements (European regulations are especially strict). Prepare terms and conditions and a privacy policy that fully discloses what user information your company will retain and/or use, outlines the general terms of use of your Website and its products/services and protects against lawsuits from users of your Website and its products/services.

If your business collects any medical records or healthcare information (South Florida has a large
concentration of healthcare companies), you need to consult an attorney who is a healthcare specialist (re: HIPAA).

Be sure to discuss your use of Open Source software with your attorney.

Securities regulations/solicitation of investors

This is a broad subject outside the scope of this article.

However, you should at least be familiar with the basics. You should not solicit investors, distribute materials about the company to potential investors, begin a discussion of financing opportunities with potential investors or permit any shareholder to sell company equity prior to consulting legal counsel.
Failure to abide by U.S. Securities laws may result in the loss of exemptions that permit pre-IPO fundraising in the U.S., and/or trigger rescission rights for the investors (i.e., investors must be given their money back), among other possible damages.
There are several new exciting fundraising options under the JOBS Act to consider when fundraising, like Regulation 506(c)(permits advertising the offer but with enhanced requirements to verify accredited investor status), Regulation A+ (like a mini-IPO, still quite burdensome) and soon to be available Regulation Crowdfunding beginning May of 2016 (offer of up to $1 million in a 12 month period to non-accredited investors, with some SEC disclosure, limits on investment amount by non-accredited investors and requirement to use a licensed funding portal), but always first speak with an attorney. It is important to think through the mechanics and procedures of securities offerings before soliciting investors.

“Failure to abide by U.S. Securities laws may result in the loss of exemptions that permit pre-IPO fundraising in the U.S. and trigger rescission rights for the investors.”

Fundraising portals offer sales under the traditional 506(b), new 506(c) and are required for Crowdfunding. These portals often provide good fundraising options and will take a cut of the proceeds and/or equity. Note that you may not compensate people who raise capital for your company who are not registered broker-dealers. There are some rare exceptions for “finders” and company employees, but don’t count on those applying, and always first speak with an attorney. Fundraising portals normally are associated qualified broker-dealers.

While these issues may sound daunting, the good news is that the world of Venture Capital relies on very
standardized documentation, for both initial formation documents and financing rounds. There is absolutely no need for any lawyer or advisor to reinvent the wheel.

Among the wonderfully efficient open-sourced sets of documents (easily found online) include those by
TechStars, Y-Combinator, SeriesSeed.com and the National Venture Capital Association, and law firms like Cooley, Goodwin Proctor and Orrick. We’ve completed many financing rounds in South Florida using such forms, including larger Series A rounds and beyond. The use of these templates by someone inexperienced in tax and legal issues as they apply to startups may result in serious issues that may prevent your company from being fundable. However, when properly used by an experienced practitioner, standardized documents can save you thousands of dollars, and even more
importantly, can save you hours and headaches on legal and accounting issues.

Now go build your company and show the world that South Florida is a place where world-class ideas can be build.

Read in pdf

 


Jason Stark is a partner at Private Advising Group, P.A., a law firm in Miami. Jason is an attorney (and also is a certified public accountant) who advises emerging and growth companies. He can be reached at Jason@private-advising.com.

The information in this article is provided for informational purposes only and does not constitute legal advice. You should not act or rely on any information contained in this article without first seeking the advice of an attorney.