Did you know that your future goals for scaling your startup influence the type of legal structure you elect for your business today?
Did you know that, chances are, your home state may not be the best place to incorporate?
Did you know that oftentimes your startup’s only real protection against competitors is your intellectual property?
No need to wonder. The most important thing you’ll create, after the product or service at the heart of your startup, is the legal infrastructure of your company. For that, you’ll need specialized legal counsel.
Anna Tharrington is a senior corporate attorney at Hutchison PLLC, which specializes in working only with entrepreneurial companies and their investors within the tech, life sciences, and healthcare services space. “That is all we do. When issues arise, we don’t need to recreate the wheel.”
Richard Crow, general counsel and vice president of CastleBranch, echoes that advice about working with specialized firms that understand startups. Through flexible fee structures, he says that some firms will “build that relationship and trust. Some will bear some risk along with you for a while.”
Tharrington and Crow provided a broad overview of some of the most common legal issues that entrepreneurs need to address in the early days of the adventure.
The legal structure you elect for your startup depends on your future goals for investment and scaling, and should reflect other factors, as well, including whether equity incentives will be offered to employees or consultants. If you’re a lone wolf wanting to test a great idea before seeking capital, an LLC may be suitable. LLCs have their advantages, but they can present disadvantages when it comes to providing equity incentives, scaling, and raising capital. The vast majority of tech startups seeking capital elect to be C corporations. Larger angel investors or VC firms prefer working with C corps as well.
While in private practice with Wilmington-based Ward and Smith P.A., Richard Crow had seen a lot of tech startups begin as LLCs because of the flexibility that structure affords. There’s no double taxation (as with a C corp), not a lot of statutory rules, no mandatory board or officers. Everything is done by contract, and you generally can run things the way you want. You could always convert to a C corp when ready to raise capital, although doing so isn’t always easy. It’s true, he says, that many tech startups opt to be C corps partly because that’s what investors expect — and often want. It may be easier to raise capital and issue stock options to attract talent, and there may be some advantageous tax effects. C corps can issue and authorize any number and class of shares and store up losses to offset income.
On a related note, Tharrington adds, founder issues such as company ownership and intellectual property need to be carefully spelled out in early-stage documentation. The typical formation packages such as those prepared by Hutchison are intended to resolve stock and intellectual-property matters, address statutory requirements for the entity, and so include employment documents for the rank and file.
How you compensate your employees, even years down the road, is also a formation question as founders work through initial equity allocations and forward-looking equity-incentive grants. But Tharrington warns of potential “gotchas”: To ensure that key personnel stay aboard and be able to vest in their stock, companies should consider whether to implement vesting on founder stock at formation. She also notes the importance of working with a lawyer who is familiar with securities regulations when issuing equity or other securities, to assure SEC compliance and avoid securities problems.
Tharrington sees the vast majority of corporate clients who want to fundraise from large angels or venture capitalists incorporating in Delaware, despite the potential for greater expense due to taxes, fees, and the necessary registered agent. That’s because Delaware has the richest history of corporate case law and a sophisticated court. Together these yield greater predictability for the company and investors.
Crow suggests that North Carolina shouldn’t be dismissed out of hand. It just depends on your goals. The beauty of North Carolina, he says, is that incorporation is easy, fairly quick, and documentation is straightforward. North Carolina has well-developed corporate law that has been revised to be more in line with leading jurisdictions. It has a business court which hears complex business cases. The judges on that court specialize in corporate and commercial matters, which leads to the same type of well-reasoned decisions and case law that made Delaware an attractive jurisdiction in which to incorporate. North Carolina is “business friendly, always competing, and the legislature is more attuned” to startups. “We know we’ll get a fair shake in North Carolina,” he says, granting that North Carolina’s corporate tax structure, although much improved, needs to be friendlier.
What Tharrington calls the “big umbrella” of IP issues covers more than just ensuring that your company owns the things being created for it. Standard protection requires good contracts with nondisclosure and perhaps noncompete and nonsolicit provisions that prevent former employees from competing with the company or from siphoning off your talent for a specified time. On the contract side, consider obtaining documents that can be used for work-for-hire parties like programmers and developers working on actual product. These documents ensure that IP is assigned and that those parties are also subject to nondisclosure and other protective provisions. At Hutchison PLLC, Tharrington puts all such considerations together in an omnibus tool for early-stage clients.
Finding good legal counsel is more than a matter of legal protection. It’s a question of efficiency. Many good firms exist. But choosing a specialized, boutique law firm tailored to early-stage entrepreneurial companies, capable of handling licensing and corporate partnering, venture capital, mergers and acquisitions as well, can yield tremendous long-term benefits.
“Lawyers aren’t cheap, but our clients would agree that those who use firms like ours early in the game come out way, way ahead,” says Tharrington who, as one of her firm’s corporate “quarterbacks,” handles big-ticket items like formation, raising capital, contracts, and exit transactions. Because they do so much of this kind of work, firms like hers can devise alternative fee arrangements, provide complete formation packages at a reasonable fee, advise on how to incentivise employees and more.
At the launch of a new venture, everything looks promising. Tharrington reminds us that a great time to work with lawyers is at the outset. Before “life happens” and plans change. Obtaining experienced legal counsel early on — proactively — creates certainty for investors and founders alike.
For more tips, check out Bloomberg News’s seven-part YouTube series on Legal Issues for Tech Start-Ups.