EDWIN L. MILLER JR. is a partner with the law firm of Sullivan & Worcester LLP. He has practiced corporate and securities law for over thirty-five years. He has extensive experience in both the public and private markets representing emerging and established technology companies in their financing, technology transfer, and acquisition activities. He has been featured in The Best Lawyers in America and is the author of Mergers and Acquisitions: A Step-by-Step Legal and Practical Guide, also published by Wiley.

Lifecycle of a Technology Company

Step-by-Step Legal Background and Practical Guide from Startup to SaleBy Edwin L. Miller

John Wiley & Sons

Copyright © 2008 Edwin L. Miller
All right reserved.
ISBN: 978-0-470-22392-5

Chapter One

START-UP PHASE

FOUNDERS’ CONTRACTUAL ARRANGEMENTS AND MECHANICS OF THE INCORPORATION PROCESS

Entrepreneurs who want to start a business are extremely diverse. They range from college dropouts (e.g., Bill Gates) to so-called serial entrepreneurs or those who have started multiple businesses in the past and always seem to want to do so again (e.g., Steve Jobs), even though many are wealthy beyond imagination. The issues surrounding the organization of start-ups differ little in these cases and do not really depend very much on the type of technology or business.

Lawyers are sometimes asked by those intending to start a business when to hire a lawyer. I like to compare the situation to when you should see a doctor. Many people dread the idea and want to put it off (particularly as they get older). But the conventional wisdom in both cases is that going early may be a bit painful, but going too late can be deadly. If the entrepreneurial idea is just coming together and the founders are short of funds, it is probably not necessary to hire a lawyer at that point. If the founders are beginning to get serious about starting the business and are beginning to devote substantial time to their idea, then going to a lawyer is essential. Believe it or not, it is not unprecedented for five founders to come in for a first interview with a lawyer thinking each is getting 50 percent of the equity.

The fundamental deal among the founders of a business is that the business entity itself owns the business idea and the associated intellectual property (IP)-trade secrets, patents, copyrights, and the like. This point is crucial. The overriding concept here is that the company is like a hub, and the spokes are all of the contributors of time, talent, energy, IP, and capital by the founders, investors, employees, and others. Those constituencies benefit from the increasing value of the hub, which is dependent on it’s ownership of all relevant assets.

Notwithstanding the hub-and-spoke concept, all of the IP need not necessarily be transferred irrevocably to the business at the outset. The scientific genius among the founders may want to defer transferring ownership of the brilliant idea until the company becomes real (i.e., gets funded) or some other milestone is achieved. In that case, it is always advisable to avoid a future change of heart to put an IP license and transfer agreement in place at the outset where the transfer irrevocably becomes effective on the occurrence of one or more specified events.

What is the role of the company’s lawyer? Once the entity is formed, all parties should understand that their lawyer’s real role and duty at that stage is to the entity, not to the individuals. The lawyer customarily counsels the founders as to the business and legal decisions they must make and what is typical in the situation, but he or she should not decide these issues for the client. To a certain extent, the goals of each founder are adverse to those of the other founders and to those of the business. If, however, every founder of every business hired his or her own lawyer at the outset of the business, the start-up industry would be in serious trouble.

It is ultimately in each founder’s interest to make decisions that are the best for the enterprise as a whole. The money to be made by each founder is as much dependent on the ultimate success of the enterprise as it is on the individual founder’s deal. For example, one or more of the founders may well be fired from the business or quit before an initial public offering (IPO) or other liquidity event. A mechanism must be put in place, if possible, to permit termination of a founder by the other founders. This mechanism is a voting agreement that specifies a board of directors composition consisting of multiple founders. Under this mechanism, a majority of the board can terminate one founder. The ability to terminate a non-performing founder is crucial to the success of the enterprise. Conversely, not permitting an unproductive founder to be fired is not in the interest of the business. Each founder should be willing to put this voting mechanism in place not knowing which end of the stick he or she is ultimately going to get: He or she may be among the board members firing another founder or may be the founder who is being fired by the board. Without an effective power structure, the business may fail simply because the founders’ time and energies are focused on dispute resolution and not on the business.

In an initial meeting between the prospective founders and their lawyer, what are the most important issues? There are several fundamental questions to be answered:

Who gets what percentage of the equity (founders’ stock) of the business?

What are the vesting terms of the stock – what do you need to do going forward to earn the right to keep all of your stock? Surely, it is not fair if one founder quits the business the day after it is founded and keeps all of his or her stock, and the other founders have to sweat it out for years with long hours and low pay in order to earn their equity (hence the term “sweat equity”).

When are the business idea and the related IP to be transferred to the enterprise: at the outset, upon funding, or upon funding from outsiders? In other words, the business has to own its IP in order to get funded and in order for the founders or others to risk working for the company. However, if the business fails before it gets funded, it is not inappropriate for a mechanism to be set up for the IP to be transferred to the founder who created it. This arrangement can be accomplished by an irrevocable license for the start-up exclusively to use the IP for some period of time and that provides for automatic transfer of the IP to the start-up on the occurrence of specified favorable events.

Who is to hold what office; who is to perform what function; and when should some or all of the founders be required to quit their jobs and join the new business full time? What happens if the business gets funded and a founder decides not to join the new company: Does that founder lose a portion of his or her founders’ stock?

How do the founders legally extract themselves from their current employment without being sued by their current employers? What are the danger areas? How do you minimize the risk of a suit by current employers for theft of trade secrets or a breach of a noncompetition covenant? What is an employee of one business permitted to do to get a new business going while he or she is employed by another company? Does a founder’s business idea really belong to his or her (former) employer?

What is the budget for the initial phase of the business, and where is the money to come from?

These issues are discussed in more detail later in this chapter.

INTRODUCTION. This section provides an overview of the main corporate and business considerations in organizing an emerging business entity. The discussion begins chronologically by addressing the question of when to incorporate. Following this is an overview of the basics regarding initial capitalization and equity allocation among founders. Next is a focused discussion of the most prevalent form of legal entity, the corporation, beginning with a discussion of choice of state and then moving on to cover the mechanics of the organization process, the corporation’s key governing documents (charter and bylaws), and other typical agreements. This section then explores the basics of corporate stock splits, dividends, and redemptions and finishes with an overview of fundamental fiduciary duty laws as they apply to officers and directors. This section assumes that the corporation has been formed under Delaware law.

WHEN TO ORGANIZE THE BUSINESS. Entrepreneurs often ask their lawyers for guidance on the timing of corporate formation and may be hesitant to form a company for any number of reasons, including the costs associated with formation, uncertainties regarding the identity of the founders, the equity split among the founders, or conflicts of interest with existing employment obligations. Although these are all legitimate concerns, there are several good reasons to form the company as early as possible. These reasons are discussed next.

Holding Periods. The earlier the company is formed, the sooner the founders’ stock can be issued and the sooner the capital gains holding period (for income tax purposes) begins to run. Upon a liquidity event in which the stock is sold, stock that has been held for one year or more will be taxed at the long-term capital gains rate, which is significantly lower than the tax rate for ordinary income. Conversely, gains on stock sold that has been held for less than one year at the time of sale are taxable at an individual’s ordinary income tax rate, which is significantly higher than the capital gains tax rate. This is not a critical factor, however, because a sale within one year of start-up is extremely rare (other than during the Internet bubble).

Cheap Stock Issues. Founders of companies often make the mistake of waiting until they have received a strong indication of interest from an investor before they decide that it is time to incorporate. Forming a company on the eve of raising capital may create a tax liability for the founders. The difference between what the founders pay for their stock and the fair market value of the stock at the time of purchase (as determined by reference to what outside investors are willing to pay) may be characterized as income, possibly resulting in significant tax liability to the founders. For example, if stock is issued to the founders at the time of formation for $.01 per share and, within a short period of time thereafter, outside investors pay $1 or more per share, the Internal Revenue Service (IRS) may take the position in connection with an audit of a founder that the founders issued themselves stock at significantly below the fair market value per share.

This risk is significantly mitigated by the issuance of preferred stock to the investors in the company. This capital structure is discussed in detail in Chapter 2, but in sum, investors will invest in a start-up only if their investment receives the protection of a preferred stock/common stock structure. To take an extreme example, imagine that the company sells 50 percent of the outstanding common stock to investors for $1 million and then liquidates the next day; in that case, the founders and the investors will split the investors’ $1 million equally. If, instead of common stock, the investors received preferred stock with a liquidation preference, upon dissolution and liquidation in that situation, the investors would get all of their money back, with nothing left for the founders. That is as it should be. Given that the founders would not realize any increase in value of their common stock in that situation, in a very early stage company, common stock typically is viewed as being worth in the range of 10 to 25 percent of the price of preferred stock. The price differential should narrow as the company matures, so that the common stock and preferred stock are priced the same at the point at which the liquidation preference of the preferred stock ceases to be of any real value.

Ability to Contract. The founders may want to establish relationships with third parties that require entering into contracts. For example, an independent contractor may be developing software code. For the company to own this code, it needs to enter into a work-for-hire agreement with the contractor. This cannot be done until the company is formed. Nondisclosure agreements (NDAs) raise a similar issue. Founders are often in contact with potential strategic partners, advisors, employees, and others at the very earliest stages of a company’s formation. Although the individual founders may, and often do, enter into these types of agreements with third parties before the formation of the company, this arrangement is not ideal; in some instances, it may raise issues regarding enforceability of the contracts by the company once it has been formed and may create potential personal liability under such contracts for the founders.

At minimum, contracts entered into by founders in their role as promoters prior to incorporation should be transferable to the corporation once formed and should then result in protection by the company of the founder from any related personal liability.

Limited Liability. The most fundamental benefit of incorporating is the protection of the corporate shield. Individual stockholders generally are not liable for the liabilities of a corporation (or limited liability company) in which they hold an equity interest. Until a corporate entity is formed, the individuals are acting in their personal capacity, and thus they may be held personally liable for their actions or omissions in conducting their business. Once a corporate entity has been formed, to enjoy the benefit of the corporate shield, certain corporate formalities must be adhered to, including the maintenance of separate corporate records and accounts, the holding of annual meetings of the stockholders and directors, and the execution of contracts and other documents in the name of the company.

CHOICE OF JURISDICTION. Once it has been decided that a corporation is the preferred form of organization for a new entity, the question of the state of incorporation remains to be answered. As a practical matter, lawyers have two choices: incorporation in the state in which they practice, or incorporation in Delaware.

Sophisticated practitioners usually incorporate in Delaware. First, Delaware corporation law is generally considered to be the most sophisticated, comprehensive, and well defined. It is extremely flexible and is updated frequently to adapt to emerging practices. It is also the most familiar to the widest range of people, including lawyers, investors, and executives. For this reason, venture capital investors, investment bankers, and others tend to be more comfortable with Delaware corporations.

Second, an emerging business often must move quickly to obtain stockholder approval. An example of this is stockholder approval of a charter amendment that may be necessary in order to close a round of financing. All major corporation statutes permit stockholder votes to be taken at a meeting or by written consent in lieu of a meeting. In contrast to many state corporation law statutes that require unanimous stockholder written consents or impose other limits, Delaware law permits such consents to be effective if signed by holders of the number of shares that would be sufficient to approve the matters at a stockholders’ meeting. Although the requirement of a unanimous written stockholder consent may be valuable protection for minority stockholders in the context of a closely held corporation (and may otherwise be seen as valuable protection for founders or other groups who are or may become minority stockholders), most companies that plan to grow quickly and obtain venture financing find this requirement of unanimity in connection with any written stockholder consent to be more of a burden than a benefit.

INITIAL CAPITALIZATION AND ALLOCATION OF EQUITY OWNERSHIP AMONG FOUNDERS. Determining how to divide the founders’ equity is one of the earliest and most difficult decisions that founders confront. Unfortunately, the discussions among founders regarding how the founders’ stock is to be divided may sometimes expose divisions among the founding team due to different motivations, concerns, risk profiles, and the like. Although such divisions present challenges to the business lawyer who is, after all, engaged to represent the corporation and not the founders, it is often in the best interests of the founders and the company to have such divisions play themselves out at the start and not remain dormant until a later date. This section offers some guidance on how to think about this sensitive and often pivotal decision in a company’s formative days.

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Excerpted from Lifecycle of a Technology Companyby Edwin L. Miller Copyright © 2008 by Edwin L. Miller. Excerpted by permission.
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