When do I need to incorporate a company?

July 20, 2009

[It’s been awhile since I wrote anything.  I am giving a presentation to some of the founders in TheFunded Founder Institute on incorporating their companies, so I thought I would recycle some thoughts.]

Founders of startup companies often wait to incorporate a company until they are confident that their concept is viable or fundable.  At some point, however, an entrepreneur will need to formally incorporate a company.  Several reasons exist for taking the step to incorporate.

  • More than one founder.  If there is more than one founder, the likelihood of an argument about how the equity should be split in the new company increases dramatically.  Incorporating a company and issuing stock to the founders will help prevent misunderstandings among the founders about equity splits.  Trying to clean up pre-incorporation promises to grant equity in a startup company is a painful task, especially if founders part ways before there are formal documents in place to deal with the situation.  Please keep in mind that even if a company is incorporated, founder stock purchase agreements with repurchase rights over unvested stock if founders leave are not included with the documents from typical online incorporation services.
  • Creating intellectual property.  If there is any IP created and there is more than one founder, then incorporating an entity and assigning IP to the entity is important.  Otherwise, if a founder leaves before incorporation and IP has not been assigned to the other founder or an entity, then use of IP created by the former founder may be problematic.  Once again, please keep in mind that the documents from typical online incorporation services do not contain IP assignment provisions in connection with the purchase of founders stock or separate IP assignment documents.
  • Hiring employees or third party contractors.  Although I’ve run into a situation where the former CEO of a Fortune 500 company personally paid an “employee” out of his own pocket for a year prior to incorporation while incubating an idea, most founders will need to incorporate a company if they intend to hire employees.  In addition, if an entrepreneur needs to engage third party contractors, it generally makes sense to incorporate a company so that the third party enters into an agreement with a company instead of an individual.  In addition, any IP created by the contractor can be assigned to the company instead of an individual founder.
  • Issuing stock options.  Many entrepreneurs do not have the cash to pay third parties and may partially compensate third parties by granting stock options or giving them the opportunity to purchase equity at nominal prices.  Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is simply easier to incorporate a company and grant stock options or equity to satisfy these promises.
  • Launching a service/product and general liability issues.  One important reason for incorporating a company is to protect the stockholders against personal liability.  If a company complies with corporate formalities, creditors of the company generally cannot reach the stockholders to satisfy the company’s liabilities.  Thus, a company should generally incorporate before launching a product or a service due to potential liability issues, as the risk of liability to a founder increases with customers or users.
  • Obtaining visas.  If a non-U.S. citizen/non-permanent resident founder intends to work in the U.S. on a startup project, then the founder should work with an immigration attorney on a strategy to legally work in the U.S.  Incorporating a company and demonstrating that it is a “real” business with sufficient capital is typically a prerequisite to a visa application.
  • Starting capital gains holding period in the event of a stock sale.  If a founder sells stock of a company in a taxable transaction and it is held for greater than one year, then the capital gains tax rate is 15% for founders in the 25% tax bracket and higher. These days, it is fairly easy to develop a hit iPhone app or Facebook app and sell a company fairly quickly.  I represented a couple of Facebook app companies last year that were sold in taxable transactions.  One app was sold by an individual founder and the app was only several months old.  Unfortunately, the founder was unable to receive the benefit of long-term capital gain tax treatment on the asset sale (and ended up paying the same tax rate as ordinary income on the sale proceeds).  The other app was sold by an individual founder and the app was only several months old, but he had the foresight to incorporate a company more than a year prior to the sale and assign IP to the company.  The buyer bought the stock of the company as opposed to the app itself.  Thus, even though the app was less than one year old, the shares of stock of the company were held for greater than one year, and qualified for long-term capital gain tax treatment.
  • Funding.  Obviously, if third party investors want to invest in a startup idea, there needs to be an entity to accept the investment.  Generally, I prefer to incorporate and issue founder’s stock at nominal prices well in advance of a Series A preferred stock financing because it is difficult to justify that common stock should be priced at $0.001 per share while Series A preferred stock is issued at $1.00 per share.

Incorporating a company is a serious step that results in out of pocket costs and ongoing tax and other filing obligations. In addition, if a founder still has a day job as an employee of another company, then the founder will need to review the founder’s employment documents carefully in order to determine if there are any issues. The first step in deciding whether to incorporate or not is to discuss the situation with a competent attorney.

What type of entity should I form?

March 12, 2009

C corps, LLCs, and S corps differ significantly in the areas of taxation, ownership, fundraising, governance and structure, and employee compensation.  Almost all technology startup companies that I work with are C corps.  Any company that raises venture financing will need to be a C corp in order to issue preferred stock.

If founders want the benefit of flow through tax treatment with respect to losses prior to an outside financing, an S corp election may make sense as long as there are no entity or non-U.S. citizen/resident stockholders.  However, S corp losses can only be used to offset personal income up to the founders’ basis in the S corp stock, which may decrease the utility of the S corp election. In any event, the S corp election can be easily revoked at the time of a financing. The legal documentation for an S corp is basically identical to an C corp.

I generally avoid LLCs as most technology startup companies need to grant options to employees and consultants, and there is no easy “off the rack” method to do this.  In addition, the conversion of an LLC to a C corp results in additional legal and accounting expense.  However, LLCs may make sense for businesses like consulting companies.

The primary differences between C corps, LLCs and S corps are outlined below.

Taxation

  • C Corps. A C corp is a separate taxable entity independent from its stockholders. Thus, the earnings of a C corporation are generally taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions. In addition, C corps often must pay higher state franchise taxes than LLCs or S corps.

Although the double-taxation feature of C corps may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.

  • LLCs. LLCs are flow through entities for tax purposes, meaning that taxable income earned by the entity is passed through to individual members. Thus, earnings are taxed only once, at the member level. An LLC may elect to be taxed as a C corp, an S corp, or a partnership. It may specially allocate items of income or loss among its various members. It may use taxable losses generated at the entity level to offset taxable income of the individual LLC members. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.
  • S Corps. Similar to LLCs, S corps receive flow through tax treatment. However, an S corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity.

Ownership (Stockholders)

  • C Corps. C corps may have an unlimited number of stockholders (subject to SEC reporting requirements if the number exceeds 500). The owners do not need to have a relationship with one another nor have a role in running the day-to-day affairs of the company. Additionally, they may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Thus, the perpetual existence of the entity is unaffected by the death or withdrawal of any one shareholder.
  • LLCs. Similar to a corporation, an LLC may have an unlimited number of members. However, ownership transferability for an LLC is not as flexible as that for a C corp. Generally, a member needs the approval of other members before selling an interest in the LLC. Also, a death, withdrawal, expulsion, or other departure of a member may constitute a termination of the LLC and a deemed liquidation for federal tax purposes.
  • S Corps. Unlike C corps. and LLCs, S corps are limited to 100 domestic stockholders. Stockholders must be individuals, with limited exceptions for certain trusts, estates, and exempt organizations. Stockholders must also be U.S. citizens or residents.  Ownership transferability is flexible and similar to that of C corps. Finally, the perpetual existence of the S corp is unaffected by the death or withdrawal of any stockholder.

Fundraising

  • C Corps. Most venture and institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. A C corp is also the easiest type of entity to take public in an initial public offering.
  • LLCs. Although LLCs may be attractive to businesses financed by a small number of corporate investors and/or individuals, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. They may be unattractive to tax-exempt venture fund investors because their investment in a flow through entity may produce unrelated business taxable income. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.
  • S Corps. S corps are not a popular entity choice because, in addition to presenting the same challenges to tax-exempt venture fund partners as those presented by LLCs, S corps are limited to one class of stock (meaning no preferred stock financings) and 100 stockholders. Such inflexible features are typically unattractive to venture investors.

Governance/Structure

  • C Corps. C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners. Management is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision. However, corporations are required to pay attention to formalities that legislatures and courts have determined to be significant (e.g., meetings of boards of directors and maintenance of corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc.).
  • LLCs. LLCs operate more informally then C corps and are either managed directly by the owners or managed by one or more owners (or an outside party) designated to fulfill such responsibility. Unlike corporations, they are not bound by corporate formalities such as holding regular ownership and management meetings. However, in contrast to corporations, they do not operate under a well-defined regime of uniformity and legal precedent.
  • S Corps. S corps operate in a manner similar to C corps. and must therefore adhere to statutory formalities for decision making.

Employee Compensation

  • C Corps. Businesses that plan to use equity incentives (e.g. stock options) to attract and retain talent often prefer to operate as C corps. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C corps. may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.
  • LLCs. While an LLC may reward employees by offering them membership interests in the LLC, the equity compensation process is awkward and may be unattractive to employees. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C corps., such as incentive stock options.
  • S Corps. Although S corps can grant stock options, they should not be granted to non-U.S. residents. S corps are less flexible than C corps with regard to fringe benefits and must either report the benefits as taxable compensation to the employees or forfeit the fringe benefit deduction available to the company.

What state should I incorporate in?

March 3, 2009

I think there are three primary choices for the state of incorporation for most technology startup companies:  (i) Delaware, (ii) the state where the company has its headquarters (i.e. California), and (iii) the Cayman Islands.

Almost all of the companies that I represent that intend to receive venture financing are incorporated in Delaware.  I represent a few pre-VC financed California companies were already incorporated by the time that I met them.  I also represent a few Cayman companies that have headquarters outside the U.S.

Reasons to incorporate in Delaware

Regardless of where the operations of a business entity are located, Delaware is frequently chosen as the state of incorporation for the following reasons:

  • Investors insist on Delaware

Almost all investors, regardless of where they are located, are familiar with Delaware corporate law.  They may also be familiar with the corporate law of state where they are located.  Because of the various advantages that Delaware law provides, most venture capital investors insist on investing in a Delaware entity. 

If a company is incorporated in another state, such as California, and needs to reincorporate in Delaware in connection with a venture financing, the company will incur additional legal expenses in connection with the reincorporation.  If a company ultimately undertakes an initial public offering of its stock, the underwriters will usually require that the entity be incorporated in Delaware.  In order to complete a reincorporation, a California company typically creates a subsidiary in Delaware and merges into it, with the Delaware company surviving.  Compliance with securities laws may be problematic if there are lots of shareholders. All contracts of the company must be reviewed in order to ensure that the reincorporation doesn’t accidentally terminate an agreement.

One example of a material difference in corporate law between states is the stockholder vote necessary to sell a company.  California corporate law provides that a merger requires the approval of a majority of the outstanding shares of each class of the corporation. This means preferred stock as a class and common stock as a separate class.  In contrast, Delaware corporate law provides that a merger requires the approval of a majority of the outstanding stock entitled to vote.  The fact that holders of common need to approve a merger of a California corporation is one reason why venture funds prefer Delaware. Venture funds don’t want common holders to have the ability to block a merger.

  • Delaware has a predictable, fair and well-developed body of corporate law

Delaware has a specialized court (the Court of Chancery) that has original jurisdiction over corporate law matters.  Because of its unique expertise on corporate and business law matters, the Court of Chancery has produced a large body of decisions that has clarified and interpreted the Delaware corporate statutes. In addition, the Court of Chancery (and the Delaware Supreme Court which hears appeals from the Court of Chancery) is focused on the timely resolution of corporate law disputes.  An appeal from the Court of Chancery may often be heard and ruled upon by the Delaware Supreme Court in a matter of days.

  • Directors of Delaware corporations are afforded a high degree of protection

While the directors of Delaware corporations have a fiduciary duty to act in the best interest of the stockholders, Delaware courts will, as a general matter and absent fraud or self-dealing, defer to the good faith business judgments made by the directors.  In addition, Delaware corporate law allows for a corporation to indemnify its directors for losses that they may incur from being sued.  Attorneys are generally more comfortable advising directors on their fiduciary duties under Delaware law as opposed to the law of any other state.

  • Complying with procedural formalities is efficient in Delaware

Observing proper corporate formalities under Delaware law is efficient, which is critical to preserving the limited liability feature of corporations.  Delaware was one of the first states to allow voting by electronic proxy and attendance at stockholder meetings through the Internet.  Additional areas of flexibility include the ability of less than all stockholders to act by written consent and the allowance of electronic signatures.  Filings, such as an amendment to a company’s certificate of incorporation in connection with a venture financing, can be made electronically and are generally accepted upon submission within a day.

In addition, Delaware law is more flexible with respect to the number of directors.  When a California corporation has two shareholders, it must have two directors, and when it has three or more shareholders, it must have three directors.  Delaware corporations are only required to have one director.

Reasons not to incorporate in Delaware

There are some reasons why a company may not want to incorporate in Delaware, including the following:

  • Delaware franchise taxes

An entity that operates in a state other than Delaware will need to comply with tax and regulatory requirements in both Delaware and the state in which it operates (including qualifying to do business as a “foreign” corporation in that state and paying the relevant fees).  In particular, Delaware has an annual franchise tax that it levies on its corporations, although this amount is generally negligible for a start-up company with few assets and stockholders.  If a company is not going to raise venture financing and will not otherwise be forced to reincorporate to Delaware, then incorporating in the state where it conducts business will save the company from paying Delaware franchise taxes.  However, the cost and hassle of reincorporating to Delaware in the future may be greater than any tax savings in the early stages of the company.

  • Non-U.S. businesses

Some companies may be initially incorporated in the U.S., but may determine that establishing an off-shore parent entity is beneficial for investment or tax reasons.  For example, some non-U.S. venture funds are prohibited from investing in U.S. companies.

Companies incorporated in tax-favorable jurisdictions like the Cayman Islands, the British Virgin Islands and Bermuda are not subject to taxation in their jurisdiction of incorporation, although depending on the nature of their operations, they may be taxed on their earnings in higher tax jurisdictions.  Thus, a Cayman company may avoid paying U.S. corporate taxes on a portion of its worldwide income. 

However, there are serious tax issues associated with establishing an off-shore parent company when there is an existing U.S. entity or if intellectual property originates in the U.S.  Thus, if there is some reason that a company may need to establish an off-shore parent company in the future, then legal and tax advisors should be consulted prior to incorporation.

The Cayman Islands has become the preferred jurisdiction for many Chinese companies.  Only companies established in the Cayman Islands, Bermuda, China and Hong Kong are pre-approved for listing on the Hong Kong Stock Exchange.  In addition, Cayman corporate law has enough flexibility to permit U.S. style preferred stock financing arrangements and most venture capital investors that regularly invest in companies with headquarters in China are familiar with Cayman law and the documents used in these financings.

What are bylaws?

February 15, 2009

The bylaws of a corporation set forth various procedures affecting the governance of the corporation.  Delaware law allows a corporation’s bylaws to contain any provision relating to the business of the corporation, the conduct of its affairs, or the rights or powers of its stockholders, directors, officers or employees, so long as the provision is lawful and consistent with the certificate of incorporation.

Generally, the bylaws set forth the responsibilities of the directors and officers, the number or range of numbers of directors, the manner of calling meetings of the stockholders and directors (including the required notice), the maintenance of corporate records, the issuance of reports to stockholders, voting and proxy procedures, the regulation of the transfer of stock and other general corporate matters.

Bylaws generally may be adopted, amended or repealed by either the board or by a vote of the stockholders.

Bylaws for startup companies are rarely customized. Occasionally, companies may include an IPO lockup or a right of first refusal on stock transfers in bylaws. This might occur if shares were not originally issued with these restrictions and a company merges into a newly-formed company in order to force these restrictions on prior stockholders in connection with a venture financing.

When a company goes public, the bylaws are typically amended to prevent stockholder actions by written consent, limit the ability of 10% stockholders to call a special meeting, and provide advance notice requirements for stockholder proposals and director nominations.

What is a certificate of incorporation?

January 25, 2009

A Delaware corporation is considered to exist when its certificate of incorporation has been filed with the Secretary of State.  Generally, the certificate is brief because very few items must be covered in the certificate to make it effective.

The certificate must include:

  • the name of the corporation (this name must contain a corporate ending such as “Company,” “Corporation,” “Incorporated,” or an abbreviation thereof);
  • a statement of business purpose;
  • the address of the corporation’s registered office in the State of Delaware and the name of the registered agent at such address;
  • a statement of the total number of shares of stock authorized to be issued and a description of the different classes of stock (if there is more than one class); and
  • the name and address of the corporation’s incorporator(s).

However, there are many matters that the corporation might choose to include.  Certain provisions are effective only if they are contained in the certificate.  Some examples of such provisions are as follows:

  • creating, limiting and regulating the powers of the corporation, the directors, and the stockholders;
  • granting any Delaware court the power to order a meeting of the corporation’s creditors and/or of the stockholders to agree to any arrangement or reorganization of the corporation;
  • granting stockholders the preemptive right to subscribe to additional issuances of stock;
  • limiting the corporation’s duration;
  • increasing the required number of votes for actions by stockholders and directors over the voting requirements set forth by statute;
  • limiting certain liabilities of directors and permitting certain indemnification of corporate agents; and
  • imposing personal liability for the debts of the corporation on its stockholders.

Delaware law allows a corporation to amend the certificate in any way it desires, so long as the amendment is lawful at the time the corporation chooses to add it to the certificate.  Before the corporation has issued its stock, the certificate may be amended by a writing setting forth the amendment and certifying that the corporation did not receive any payment for its stock.  The writing should be signed by a majority of the incorporators, if the directors have not been elected or listed in the original certificate, or by a majority of the directors if they have been elected and named in the original certificate.  Once stock has been issued, the certificate generally may be amended or repealed by approval of the board and both the holders of a majority of the outstanding shares entitled to vote and the holders of a majority of the outstanding shares of each class of stock entitled to vote.  Once an amendment is adopted, the corporation must file a certificate of amendment with the Delaware Secretary of State to make the amendment effective.

In some states such as California, the certificate of incorporation is referred to as the articles of incorporation.  Many people use the term certificate or articles interchangably to describe the certificate/articles of incorporation.

A sample certificate of incorporation is below:

CERTIFICATE OF INCORPORATION OF
[INSERT COMPANY NAME]

ARTICLE I

The name of the corporation is [insert company name] (the “Company“).

ARTICLE II

The address of the Company’s registered office in the State of Delaware is [Corporation Trust Center, 1209 Orange Street, Wilmington, New Castle County, Delaware 19801]. The name of its registered agent at such address is [The Corporation Trust Company].

ARTICLE III

The purpose of the Company is to engage in any lawful act or activity for which corporations may be organized under the Delaware General Corporation Law, as the same exists or as may hereafter be amended from time to time.

ARTICLE IV

This Company is authorized to issue one class of shares to be designated Common Stock. The total number of shares of Common Stock the Company has authority to issue is [10,000,000] with par value of $[0.001] per share.

ARTICLE V

The name and mailing address of the incorporator are as follows:

[insert name of incorporator]
[insert mailing address of incorporator]

ARTICLE VI

In furtherance and not in limitation of the powers conferred by statute, the board of directors of the Company is expressly authorized to make, alter, amend or repeal the bylaws of the Company.

ARTICLE VII

Elections of directors need not be by written ballot unless otherwise provided in the bylaws of the Company.

ARTICLE VIII

To the fullest extent permitted by the Delaware General Corporation Law, as the same exists or as may hereafter be amended from time to time, a director of the Company shall not be personally liable to the Company or its stockholders for monetary damages for breach of fiduciary duty as a director. If the Delaware General Corporation Law is amended to authorize corporate action further eliminating or limiting the personal liability of directors, then the liability of a director of the Company shall be eliminated or limited to the fullest extent permitted by the Delaware General Corporation Law, as so amended.

The Company shall indemnify, to the fullest extent permitted by applicable law, any director or officer of the Company who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (a “Proceeding“) by reason of the fact that he or she is or was a director, officer, employee or agent of the Company or is or was serving at the request of the Company as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with any such Proceeding. The Company shall be required to indemnify a person in connection with a Proceeding initiated by such person only if the Proceeding was authorized by the Board.

The Company shall have the power to indemnify, to the extent permitted by the DGCL, as it presently exists or may hereafter be amended from time to time, any employee or agent of the Company who was or is a party or is threatened to be made a party to any Proceeding by reason of the fact that he or she is or was a director, officer, employee or agent of the Company or is or was serving at the request of the Company as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with any such Proceeding.

Neither any amendment nor repeal of this Article, nor the adoption of any provision of this Certificate of Incorporation inconsistent with this Article, shall eliminate or reduce the effect of this Article in respect of any matter occurring, or any cause of action, suit or claim accruing or arising or that, but for this Article, would accrue or arise, prior to such amendment, repeal or adoption of an inconsistent provision.

ARTICLE IX

Except as provided in Article VIII above, the Company reserves the right to amend, alter, change or repeal any provision contained in this Certificate of Incorporation, in the manner now or hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation.

I, the undersigned, as the sole incorporator of the Company, have signed this Certificate of Incorporation on [insert relevant date].

______________________________________
[insert name of incorporator]
Incorporator

What do you need to do before you quit your job to form a startup company?

January 8, 2009

There are various things a potential founder of a new startup company needs to do before quitting their job.

1. Review all agreements with your current employer.  Most employees may have signed an offer letter and a confidential information and invention assignment agreement, as well as other documents such as a stock option agreement.  Depending on the company and the employee, other relevant documents might include a employment agreement, employee handbook, conflict of interest policy or severance/separation agreement. These documents should be reviewed carefully for provisions that may inhibit the future startup company.  Enforceability of some provisions in these documents, such as non-compete clauses, generally depends on the state where the employee is located.

Reviewing the documents for the following provisions is important.

  • Confidentiality.  All technology companies require employees to sign a confidentiality agreement that prevents the employee from using or disclosing employer confidential information except for the benefit of the employer.  These confidentiality provisions are typically for an indefinite period of time, as opposed to a finite period like five years.  In any event, most states prohibit the misappropriation of trade secrets as a matter of law, regardless of whether the employee signed a confidentiality agreement or not.  Thus, a potential startup company founder needs to ensure that he/she does not use former employer confidential information in connection with the new company.
  • Invention assignment.  In addition, all technology companies require employees to assign inventions created during employment to the employer.

A typical invention assignment clause provides:

I agree that I will promptly make full written disclosure to the Company, will hold in trust for the sole right and benefit of the Company, and agree to assign and hereby do irrevocably assign to the Company, or its designee, all my right, title, and interest in and to any and all inventions, original works of authorship, developments, concepts, improvements, designs, discoveries, ideas, trademarks, or trade secrets, whether or not patentable or registrable under patent, copyright, or similar laws, which I may solely or jointly conceive or develop or reduce to practice, or cause to be conceived or developed or reduced to practice, during the period of time I am in the employ of the Company (including during my off-duty hours), or with the use of Company’s equipment, supplies, facilities, or Company Confidential Information, except as provided in Section 3.F below (collectively referred to as “Inventions”).

In California, there is an exception to this requirement to assign inventions if the employee has made the invention on his/her own time not using company equipment and the invention does not relate to the business of the company or did not result from work for the company.  California Labor Code Section 2870 provides:

(a) Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either:

(1) Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or

(2) Result from any work performed by the employee for the employer.

(b) To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded from being required to be assigned under subdivision (a), the provision is against the public policy of this state and is unenforceable.

However, an employee may still need to notify the company of an non-assigned invention under the terms of the invention assignment provision.  Occasionally, I have seen invention assignment clauses that require the employee to assign inventions created for a certain period of time after termination of employment, from six months to a year.  These clauses may be enforceable depending on the state and the facts and circumstances of the situation.

  • Invention disclosure.  Even if an employer does not require post-termination invention assignment, some employers include provisions in standard documents that require the employee to disclose inventions created (or patents filed) for a certain period of time after termination of employment.  This is less common and may be enforceable if it is reasonably necessary to protect the company’s business interests.
  • Non-compete.  In many states, non-competes are enforceable if they are reasonable in scope and duration.  However, non-competes are generally not enforceable in California except for limited exceptions, including in connection with the sale of a business.  Therefore, most startup companies located in California do not have non-compete provisions in their standard employee documents.  A typical non-compete clause provides:

A. During the term of my employment with the Company and period of twenty-four (24) months immediately following the termination of my employment relationship with the Company for any reason or any other amount of time as determined by the Company in accordance with the terms of my Employment Agreement thereafter (the “Noncompete Period”), I will not, directly or indirectly, for myself or any third party other than on behalf of the Company, without the prior written consent of the Company:

(1) engage in the “Geographic Area” (as defined below) as an employee, agent, consultant, advisor, independent contractor, proprietor, partner, officer, director, or otherwise of a Competing Business (as defined below);
(2) have any ownership interest (except for passive ownership of one percent (1%) or less in any entity whose securities have been registered under the Securities Act of 1933 or Section 12 of the Securities Exchange Act of 1934 or the securities laws of any other jurisdiction of the United States) in a Competing Business; or
(3) participate in the financing, operation, management, or control of a Competing Business.

B. “Competing Business” shall mean any firm, partnership, corporation, entity, or business that [___________].

C. The “Geographic Area” shall mean anywhere in the world where Company conducts business.

A potential startup company founder needs to review carefully the scope of the definition of Competing Business and the time period of the non-compete.

  • Non-solicit of customers and vendors.  Some employment documents also include a prohibition on soliciting customers and vendors of the employer.  In states like California where non-competes are generally not enforceable, provisions on non-solicitation of customers and vendors are likely to be considered a restraint on trade and not enforceable.  A typical non-solicit clause provides:

I also agree that for a period of twelve (12) months immediately following the termination of my employment relationship with the Company for any reason, I will not directly or indirectly solicit, divert or accept business from, or otherwise take away or interfere with, any customer or vendor of the Company, including any person or entity who was a customer or whose business was being pursued by the Company on or prior to the date upon which my employment relationship with the Company terminated.

  • Non-solicit of employees.  Most technology companies require employees to refrain from soliciting employees for a specified term, such as one year after termination of employment.  Thus, startup companies where founders intend to hire their former co-workers need to carefully navigate the bounds of permissible action under these clauses.  Please also keep in mind that key employees of company may be subject to fiduciary duties to the company and may be subject to claims of breach of fiduciary duty, fraud and intentional interference with contract for soliciting co-workers even in the absence of written agreements.  A typical non-solicit of employees clause provides:

I agree that for a period of twelve (12) months immediately following the termination of my relationship with the Company for any reason, whether voluntary or involuntary, with or without cause, I shall not either directly or indirectly solicit any of the Company’s employees to leave their employment, or attempt to solicit employees of the Company, either for myself or for any other person or entity. I agree that nothing in this Section 8 shall affect my continuing obligations under this Agreement during and after this twelve (12) month period, including, without limitation, my obligations under Section 2A.

  • No moonlighting.  Some employment documents contain explicit provisions that prevent employees from working on business activities unrelated to their employer, even if it is after hours.  This may limit pre-resignation activities.  A typical clause might provide as follows:

I agree that during the term of my employment with the Company, I will not engage in or undertake any other employment, occupation, consulting relationship, or commitment that is directly related to the business in which the Company is now involved or becomes involved or has plans to become involved, nor will I engage in any other activities that conflict with my obligations to the Company.

Some companies may have provisions that limit outside activities, whether related or unrelated to the employer’s business.

  • No conflicting stock ownership or directorships.  Some company conflict of interest policies prevent an employee from investing or holding outside directorships in other companies.  This may limit pre-resignation incorporation of a new company.  A typical conflict of interest policy provides:

The following are potentially compromising situations that must be avoided:

Investing or holding outside directorship in suppliers, customers, or competing companies, including financial speculations, where such investment or directorship might influence in any manner a decision or course of action of the Company.

2.  Return confidential information.  Most employment-related agreements require employees to return all company property to the employer.  A typical clause provides:

Upon separation from employment with the Company or on demand by the Company during my employment, I will immediately deliver to the Company, and will not keep in my possession, recreate, or deliver to anyone else, any and all Company property, including, but not limited to, Company Confidential Information, Associated Third Party Confidential Information, as well as all devices and equipment belonging to the Company (including computers, handheld electronic devices, telephone equipment, and other electronic devices), Company credit cards, records, data, notes, notebooks, reports, files, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, photographs, charts, any other documents and property, and reproductions of any and all of the aforementioned items that were developed by me pursuant to my employment with the Company, obtained by me in connection with my employment with the Company, or otherwise belonging to the Company, its successors, or assigns, including, without limitation, those records maintained pursuant to Section 3.C. I also consent to an exit interview to confirm my compliance with this Section 5.

Employees should carefully search all electronic and paper files for any employer material, including temporary internet files, emails sent to personal addresses, email contacts, and other types of information.  The inadvertent retention of these materials can be used by the employer in future litigation.

3.  Limit pre-resignation activities.  Creating intellectual property related to the current employer’s business, or otherwise using the current employer’s time or resources can be problematic due to typical invention assignment clauses in employee documents.  Employees must avoid using equipment (including employer-provided laptops), time, know-how, or other resources of their employer in connection with their new startup company.  In addition, no customers should be solicited for the new company, and no co-workers should be invited to quit and join the new company before resignation.

However, some pre-resignation planning is permissible to some extent. In general, describing general concepts for a new company that fall short of intellectual property creation and meeting with potential investors is permissible subject to the potential contractual limitations described above.  Investor presentations should be carefully drafted to avoid any inference that IP has already been created. Incorporating a company before resigning is probably also permissible subject to the same potential contractual limitations, keeping in mind that certain facts may seem bad in later litigation.

Keep in mind that key employees, such as officers, directors and managers) may owe a duty of loyalty to the company, regardless of whether there is a written agreement.  This duty would prohibit an employee from doing anything to harm the employer, such as competing with the employer or usurping and business opportunities of the employer.

4.  Prepare for the exit interview.  Many employee documents require employees to submit to an exit interview.  Prospective founders of a startup company should not lie in an exit interview if they are asked about their plans.  While there is no particular obligation to tell the truth, even a slight misrepresentation may be used against the founder in future litigation to show dishonesty.  Departing employees should prepare a high level, but truthful response to any direct inquiries by an employer regarding future plans. If the potential founder is going to form a competing company, the former employer will learn about it anyway if it is successful.

Departing employees must also be prepared to make written representations to their prior employers that they have returned all company information and material, and will continue to comply with confidentiality obligations.  A typical representation is as follows:

This is to certify that I do not have in my possession, nor have I failed to return, any devices, records, data, notes, reports, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, equipment, any other documents or property, or reproductions of any and all aforementioned items belonging to the Company.

5.  Stay on good terms.  Sometimes litigation arises simply because the former boss of a departing employee has a vendetta against the employee.  Keeping on good terms with your former employer may also be helpful if the employer might be a potential investor, customer or supplier for the new startup company.

6.  Don’t forget about stock options and benefits.  Most stock options expire within 90 days of the last day of employment. In some cases, the time period is shorter than 90 days.  If you want to exercise a stock option from your current company, you need to make sure that you do it within that time period.  Of course, exercising a stock option will require the employee to pay the exercise price for the options, and in some cases, the aggregate exercise price may be significant.  In addition, employees should make sure they understand COBRA insurance and how to transfer their 401(k) plans, along with other benefits issues.

7.  Consult with an attorney.  (I will write a post on “How do I find and hire a lawyer” in the near future.)  Many of issues described above are fairly tricky and the advice of a competent attorney is recommended.  In addition, if there are any potential issues regarding intellectual property ownership with former employers, consulting with an attorney is extremely important.  In fact, a general corporate attorney (like me) is probably not the right person to deal with a situation where there may be an IP dispute.  I typically get one of my IP litigation colleagues involved if there is any likelihood of a problem.  IP issues will come up in due diligence in a future venture financing or a sale of company, so it is extremely important to make sure things are done correctly from the very beginning.

What does fully-diluted capitalization mean?

August 17, 2008

“Fully-diluted” capitalization typically includes (1) all outstanding common stock, (2) all outstanding preferred stock (on a converted to common basis), (3) outstanding warrants (on an as exercised and as converted to common basis), (4) outstanding options, (5) options reserved for future grant, and (6) any other convertible securities on an as converted to common basis.

The concept is what number of shares is already “spoken for.”

Authorized, but unissued stock, is not counted in the fully-diluted capitalization number.

What is par value?

July 18, 2008

Par value is the minimum price per share that shares must be issued for in order to be fully paid. I typically recommend that par value be set at $0.001 or $0.0001 per share.  Thus, if a founder purchases 8,000,000 shares of common stock, the minimum price that the founder has to pay is $8,000 at $0.001 per share or $800 at $0.0001 per share.  Par value can even be set lower, such as $0.00001 per share, in order to minimize the amount paid for founders.  Some states, like California, allow for no par value shares.

What trademark and other legal issues are involved in selecting a company name?

March 7, 2008

[The following post is courtesy of John Slafsky and Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group.]

Among the most important tasks in the founding of a new company are the development and clearance of a company name.  There are two very different sets of legal issues, and a host of business issues, involved in the process.

Legal Issues

One set of legal issues concerns availability of the name under state law relating to entity names.  In the case of corporations or limited partnerships, this involves checking with the Secretary of State of the states where they are formed and where they must “qualify” to do business (usually where they have offices or resident employees or a sales force).

The Secretary of State checks the state records to ensure that there is no other corporation or limited partnership with an identical or closely similar name; if one is found, the new name is generally not permitted.  This happens even if the two companies are in vastly different lines of commerce; the sheer similarity of the name bars the second name.  (On some occasions, consent of the earlier company or a relatively minor alteration of the name, such as “ULTIGRA, INC.” to “ULTIGRA SOFTWARE, INC.,” may increase the chances that the state will allow the new name.)

The second set of legal issues concerns trademark law.  The Secretary of State’s approval of a business name does not grant trademark rights or authorize a company to use a particular business name in commercial activities.  (Nor does registration of a corresponding domain name result in any significant legal rights.)  A company may have incorporated under a name but find itself liable for trademark infringement or dilution — with potential risks of an injunction, disgorgement of profits, payment of damages, and more — for use of the name.

Trademark infringement occurs when a person or company uses a name or mark in a way that causes a likelihood of confusion with another person or company with respect to source, sponsorship, or affiliation of products, services, or commercial activities.  Thus, “McCoffee” may infringe upon the marks of McDonald’s Corporation by leading the public to believe that “McCoffee” is a product or an affiliated company of McDonald’s.  A company also may be liable for trademark dilution by using the famous mark of another company even if there is no competitive overlap or likelihood of confusion. For example, the name “Pentium Petroleum Corporation” may well dilute the PENTIUM trademark of Intel Corporation.  It therefore is important to assess the potential trademark law risks of a name before adopting it as a company name.

The fact that a company still has a low public profile, or does not yet have products on the market and does not yet have a website, does not immunize it from challenges.  Some companies have been sued for allegedly causing confusion through their financing activities or for use of a pre-release code name for a new product.

Some companies, in a rush to form a company, devise names in a hurry and do not clear them for trademark purposes.  Often, they consider the name a “place holder” until a later time when they can invest the money and effort to attend to a new name.  This creates a number of risks.  First, there is the risk of liability.  Second, management may “fall in love” with the placeholder name and become unwilling to give it up later.  Third, the company may develop goodwill under the placeholder name that will be lost upon a name change.  Fourth, the company may incur significant legal and administrative costs when it later undergoes a name change.

Our Assessment

Legal assessment of a business name involves several steps.

We check the availability of the name with the Secretary of State for the relevant states; if the name is available with the Secretary of State, we reserve it pending an in-depth search.  The Secretary of State availability check and reservation require only nominal fees.

We also perform searches of trademark databases in-house using on-line services or other research materials.  The purpose of the searches is to determine whether a name is so likely to be unavailable that a more comprehensive search would be wasteful.  A preliminary screening search is not sufficient diligence to assess the real issues in adoption of the name.

After the screening search, we obtain an in-depth trademark search from an outside search company.  It examines federal and state trademark registers and a large number of sources of unofficial information about company and product names in relevant fields.  We obtain an extra copy of the search report for our client and expect it to review the report carefully for potential conflicts; we then discuss our assessment with the client. 

Once a company is comfortable with the level of risk of its chosen name, it is important to find ways to protect the name.  If the name will be used on products, or in connection with the advertising or promotion of services, it often is a good idea to file an application for federal registration of the name based on the company’s intent to use the mark.  This will help establish rights to the name; more importantly, it gives early notice to others who might otherwise overlook the company’s name when they do searches to develop their own names.

For further information, please contact John Slafsky or Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group

What inspection and information rights does a stockholder have?

February 9, 2008

Most states allow stockholders to demand access to a corporation’s books and records, and a stockholder list, as long as the stockholder has a proper purpose and meets certain procedural requirements.

Delaware General Corporation Law Section 220(b) provides that “Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from … [t]he corporation’s stock ledger, a list of its stockholders, and its other books and records …”

A stockholder that wants to exercise inspection rights should probably engage an experienced attorney because a corporation can reject the request for failure to comply with procedural requirements.

If the corporation refuses to permit an inspection or does not reply to the demand within 5 business days, the stockholder may apply to the Delaware Court of Chancery for an order to compel such inspection.

One requirement for exercising inspection rights is a proper purpose for the demand.  Section 220(b) provides that “[a] proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder.”

Delaware courts have held that the following purposes, among others, are proper:  gather information prior to filing a stockholder derivative suit, communication with other stockholders regarding a solicitation of proxies, communication with other stockholders regarding a stockholder class action against the corporation, communication with other stockholders for the purpose of influencing management to change its policies, communication with other stockholders to encourage them to dissent from merger and seek appraisal, valuation of one’s stockholdings, and investigation of suspected mismanagement where some credible basis for the stockholder’s suspicions is shown to exist.

Courts have rejected inspections for purposes such as:  gaining information to facilitate a tender offer when the stockholder has already been enjoined from pursuing a tender offer, valuing the company as a whole in order to determine whether to increase one’s bid in a tender offer, gathering information for use in a stockholder’s individual employment-related claims against the corporation, obtaining information to use to exert economic pressure upon a third party in connection with a labor union’s strike, or satisfying idle curiosity.

If a stockholder seeks to inspect only the corporation’s stock ledger or list of stockholders, the burden of proof is on the corporation to establish that the inspection if for an improper purpose.  If the stockholder seeks to inspect the corporation’s books and records, other than its stock ledger or list of stockholders, then the burden of proof is on the stockholder to show a proper purpose.

A stockholder will be entitled to inspect documents that are essential and sufficient to the accomplishment of the proper purpose.  The Court of Chancery may “prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.” A stockholder may be required to execute a confidentiality agreement in order to exercise inspection rights.

Given that disgruntled stockholders can create problems by exercising inspection rights, companies should be careful about their stockholder base.

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