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Losing Limited Liability: Blending Business and Personal Finances in a Corporation or LLC

 

In the early stages of starting a new business, it can be difficult to tell what belongs to the company and what belongs to the founders as individuals. Even after a business is formally incorporated as a corporation or limited liability company (LLC), the distinction between the person and the entity may not be clear, either from a practical perspective or an emotional one. With this in mind, it can be tempting for startup founders to blend their own finances with those of the business. After all, it often seems (perhaps even accurately) that the money is going to go to or come from the same place when all is said and done. Why not streamline things by cutting out some of the intermediate steps?

The reason why it is so important to keep personal finances and company finances separate is that failure to do so has a number of practical consequences. These range from tax implications—blending personal and corporate accounts can be a nightmare when it comes to filing taxes or preparing for an IRS audit—to the complete loss of some of the key advantages of incorporating in the first place. This blog addresses only one of these consequences: specifically, the risk that commingling corporate and personal finances can lead to the loss of owners’ limited liability for business debts or wrongdoing.

 

Loss of Limited Liability

One of the major reasons that founders choose to form a corporation or LLC for their own business is to limit their own liability in the event that the business is sued. Unlike a partnership or sole proprietorship, a corporation limits the degree to which the founders can be on the hook for any debts undertaken or legal wrongdoing engaged in by the company. Normally, corporate ownership will not be liable for more than the amount of capital they have already invested in the business. Their personal assets remain off-limits.

The limited liability aspects of a corporation are only fully effective, however, if the founders clearly differentiate between and separate their personal finances and the company’s finances. This is because, in some circumstances, courts may “pierce the corporate veil” and impose liability on officers, shareholders, directors, or members. A court may pierce the corporate veil if all the following requirements are met:

  1. There is no real separation between the company and its owners
  2. The company’s activities were wrongful or fraudulent
  3. The company’s creditors suffered some unjust cost, such as unpaid bills or court judgments.

Some of the most common factors courts consider in determining whether these requirements are met include the following whether the corporation failed to follow corporate formalities, whether the corporation was improperly capitalized (i.e., if the company never had sufficient funds to operate on its own), and whether a small group of closely related people hold complete control over the company. Because of their size and business practices, startups and other small, closely held companies are particularly prone to losing their limited liability status under this framework. Smaller companies are less likely to follow corporate formalities and, more importantly, more likely to mix business and personal assets.

Courts often look for whether there has been commingling of corporate and personal assets in determining whether a corporation or LLC is little more than an alter ego for its owners. Commingling of assets may occur, for example, if a business owner pays personal debts using a corporate bank account or deposits checks made payable to the business into their own personal bank account. These kinds of activities should be avoided in order to keep the company’s limited liability status.

 

What Startups Should Do

To avoid these kinds of problems, there are a number of steps startup founders and owners should take, including the following:

  • Establish separate checking accounts for the business and for your personal assets, and also consider establishing a distinct business savings account.
  • Pay for business expenses only out of the business account.
  • Pay for personal expenses only out of a personal account.
  • Obtain a dedicated business credit card, and use this card to complete business-related transactions. If your business’s credit is not sufficiently established to qualify for a card, at the very least designate one of your personal cards that will be used only for business-related expenses.
  • Any money transferred to the business owner, including salary and dividends, should be transferred according to specific, formal protocols, not in an ad hoc fashion. Do not skip any intermediate steps.
  • Make a reasonable initial investment in the business so that the company is sufficiently capitalized and will not require regular payments of debts from your personal accounts.
  • Make sure that business assets and liabilities, including loans, are titled in the business’s name.

These suggestions are just a few of the steps that a business owner can take to maintain corporate limited liability status. Distinct finances alone will not protect this status if other factors, such as a complete lack of corporate formalities, are present. But keeping business and personal accounts separate is a good initial step towards ensuring that some of the key advantages of the corporate form, including limited liability, are actually available.

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What’s So Great About a Delaware C-Corporation?

If you’ve spent any time looking at U.S. companies, you’ve likely noticed that an unusually large number are organized as Delaware C-Corporations. Similarly, many startup founders seeking to choose a business entity are counseled to form Delaware C-Corporations. But with so many great states to incorporate in, you’re probably asking yourself, “What’s so great about a Delaware C-Corporation?”

For many decades, Delaware has made itself the destination of choice for U.S. companies through its General Corporation Law. Delaware corporate law favors directors and minority shareholders relative to other states, provides for tough antitakeover laws, and protects the identifies of shareholders and directors. These policies are thought to attract businesses on the theory that the directors and managers enjoy better flexibility and protections. Additionally, Delaware’s non-taxation of royalty payments allows corporations to avoid some tax in other states by transfering intangible assets to Delaware.

Once a business is based in Delaware, disputes are litigated in front of the Court of Chancery, perhaps the most well-known advantage of doing business in Delaware. The Chancery Court is one of the nation’s oldest equity courts and it spends almost all of its time hearing corporate cases, typically without a jury. As a result, the five judges of the Chancery Court are some of the nation’s leading experts in business law who are capable of hearing and deciding complex corporate cases with remarkable efficiency and understanding. Additionally, the extensive case law coming out of the Chancery Court has created a well-known and predictable set of rules for corporations in the state.

It is important to note, however, that Delaware is not the only state competing for businesses and there is some evidence that the benefits of a Delaware C-Corporation are minimal or fail to justify the costs. In the face of this evidence, the fact that Delaware continues to be the go-to state for C-Corporations illustrates one of its most significant advantages – inertia. Delaware’s long-standing reputation means that today’s corporate lawyers often choose Delaware by default. Venture capitalists and angel investors generally require a Delaware C-Corporation, as do many investment bankers looking to take a company public. In general, a Delaware C-Corporation is a signal to the market that you’re a “serious” company. For all of these reasons, Delaware is unlikely to lose its favored status in the near term.

The benefits of a Delaware C-Corporation include the state’s corporate and tax laws, the Court of Chancery, and the inertia created by decades of developing a business-friendly reputation. While a Delaware C-Corporation doesn’t make sense for many startup companies, a significant portion of successful startups will end up converting to that form. In any case, these advantages illustrate why so many companies are formed as Delaware C-Corporations and why that that will continue to be the case in the foreseeable future.

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Series LLCs: An Uncertain Innovation

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Given the ubiquity of the LLC today, it’s easy to forget that in its early days the LLC wasn’t always the go-to legal form for founders who wanted the benefits of limited liability without the hassles of incorporation. As Vicki Harding notes in an article in the Michigan Business Law Journal, when the LLC was still a novel legal construct, founders often shied away from the form. In those early days, it was not clear how courts in states without LLC statutes would treat LLCs that had been formed in other states. Faced with this legal uncertainty, founders elected to form more traditional legal entities rather than risk an adverse judgment in a state court that refused to recognize the LLC’s liability protections. Today, a similar phenomenon can be seen in a more recent legal innovation: the series LLC.

A series LLC is a group of limited liability entities that operate under one parent entity that is registered with the state. The parent is usually referred to as the “series LLC,” and the constituent entities are called “series.” Each series is treated as an independent LLC with its own assets and liabilities. Creditors of one series cannot reach the assets of another series.

While series LLCs are often associated with venture capital funds and real estate management companies, entrepreneurs who want to engage in multiple “synergistic” lines of business might be drawn to the form, too. A tech startup, for example, might want to simultaneously explore several potentially viable lines of business. The series LLC would allow the tech startup to do that, while protecting each line of business from the liabilities of the others. The startup could create the same liability structure by founding several independent LLCs, but that approach would typically involve more work and more taxes and fees. Often, forming a series LLC is a thriftier alternative.

However, there’s a catch. Only a few states have adopted series LLC laws, and the courts in states without series LLC laws may not recognize the liability limitations series LLC laws provide. Founders who wish to operate in states without series LLC laws should consider whether the benefits of forming a series LLC outweigh the risks posed by the legal uncertainty surrounding their liability limitations.

Whether this uncertainty will ever be resolved is an open question. It doesn’t look like the series LLC is catching on as quickly as the LLC did. The first series LLC statute was passed twenty years ago, and next year marks the fortieth anniversary of the nation’s first LLC statute. The series LLC is already half as old as the regular LLC, yet little progress has been made toward its nationwide adoption. Ten years ago, the National Conference of Commissioners on Uniform State Laws declined to introduce series LLCs into the Revised Uniform Limited Liability Company Act. Vicki Harding reports that the Commissioners found “difficult and substantial questions remain[ed] unanswered,” including whether the series form would be respected in state courts of states without series LLC laws. They concluded that “[g]iven the availability of well-established alternative structures (e.g., multiple single member LLCs, an LLC ‘holding company’ with LLC subsidiaries), it made no sense for the Act to endorse the complexities and risks of a series approach.” To date, only eleven states (Alabama, Delaware, Illinois, Iowa, Kansas, Missouri, Montana, Nevada, Oklahoma, Tennessee, and Texas), the District of Columbia, and Puerto Rico have adopted series LLC laws. In non-series states, there seems to be very little case law on series LLCs, perhaps because few people form series LLCs for out-of-state operations. For example, no Michigan court has had occasion to rule on whether series LLCs are effective in Michigan.

Is it worth it?

For founders of entities that will do business only in a series-LLC state, forming a series LLC in that state is a low-risk option (provided of course there’s no reasonable likelihood the entity will be subject to suit in a non-series state). In series-LLC states, entrepreneurs participating in the local business scene (e.g., restauranteurs, property managers, independent retailers) might find that forming a series LLC saves them time and money.

Founders who will do business in non-series states need to consider whether the advantages of the series LLC outweigh the risk that a state court could hold the entire series LLC liable for the obligations of one of its constituent series.

Some states, like Illinois and Delaware, have higher than average franchise taxes and filing fees. In Illinois, it costs $750 just to file articles of organization for a series LLC. In Michigan, you could file fifteen separate LLC articles for the same amount of money. The entrepreneur will have to do the math, but in some cases it could be cheaper to form multiple regular LLCs, even before discounting for the risky nature of series LLCs.

Can a series LLC preserve limited liability when it operates out of state?

If a founder is willing to risk forming a series LLC that will operate in non-series states, he or she should carefully consider where to form the series LLC. Series LLC laws differ slightly from state to state, and those differences may have interesting legal implications for a founder who wants to operate a series LLC in a non-series state. For example, Vicki Harding explains that an entity that registers under Illinois law can obtain from the Illinois government a certificate of good standing for any single series in its series LLC. The entity can use that certificate to register the series to do business in other states and may thus preserve its limited liability. However, if the entity chooses to register under Delaware law, it can only get a certificate of good standing for the series LLC as a whole, and registering to do business in a non-series jurisdiction with that certificate could lead a court to treat the entire series LLC as a single entity for liability purposes.

Conclusion

The series LLC may well end up being a niche product, but for those who aren’t worried about ensuring they have limited liability in non-series states, forming a series LLC might be the least expensive way to structure a group of ventures in a way that preserves limited liability for each of them.

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When Should a Business Incorporate?

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Although this is a complex question, thinking about it sooner rather than later may help the startup survive cofounder conflicts such as equity distribution disagreements. The reality is that founders should start to think about incorporating as soon as they have seriously considered starting a business on their own, or have a group of people that are starting the business with them. Many problems can arise at the early stages and incorporating may be able to help the startup get through them. Finding a good attorney can help founders navigate the maze of legal complexities and provide guidance through the tough conversations to come.

There is no clear answer as to when is the right time to incorporate, but there are some situations that indicate a business is ready for this step.

 

Is there more than one founder who is contributing intellectual property (IP) or could claim equity?

If so, then it is definitely time to incorporate. When the business incorporates, an independent legal entity is created. This provides some clarity when the question of who owns the IP comes up — assuming the employees have assigned their IP to the company. The line is clearer as to who owns the IP when the business has a separate legal entity than when there is no clear separation between the business and the founder.  You can read more about IP assignments here.

Finally, if there is more than one founder who could claim equity, then the business should be incorporated. Before any of the founders start to do substantial work for the business, especially in regards to technical or engineering work, it is imperative that the business incorporate. Otherwise, if there is any disagreement, then any of the founders could simply walk away with all of their work product without any legal repercussions. Also, in general, incorporating will make it easier to figure out who gets equity and how much.

 

Is one or more of the founders signing contracts or conducting business?

If the business is not incorporated, then the founders become personally liable if something goes wrong. When the business incorporates, it can sign contracts, borrow money and do things that a “person” could do. Because the business is a legal person, the creditors are generally only able to go after the business assets. This means that a founder’s personal assets are protected. In addition, incorporation, as mentioned above, will make it clearer to see who the business is at any point.

If one of the founders is signing the contracts, and later on, the business is incorporated into an entity such as an LLC or C-Corporation, then the founder may still be personally liable for these contracts. Because the corporation did not exist yet, it is not clear that the corporation was the one signing the contract.

 

Does the business have any employees? Are they getting paid with equity?

The business should be incorporated before employees are even hired, but if the business already has them, then it is imperative to incorporate immediately. This will make it easier to protect personal assets. An employer is responsible for any actions that the employee takes that is within the scope of the employment. Thus, if the employee makes a mistake or is negligent while conducting business, then the founder’s personal assets may be at risk — unless a business entity has been formed. In addition, it is easier to grant equity when the business is incorporated. Hence, if the founder is planning to grant equity as a form of payment, then it is time to form an appropriate business entity that meets those needs.

 

Is the business in need of investors?

Even if an investor is interested in supporting an entrepreneur, she may not be able to invest in the business if there is no legal entity to accept the investment. Furthermore, investors actually prefer certain types of legal entities and will not invest unless the company is incorporated as such. Investors want to make sure that their interests are protected; the structure of certain types of companies provide these protections.   

 

Is there a problem if the founders wait to incorporate?

Forgotten Founder: One of the biggest issues that may arise if the business does not incorporate at the right time is the forgotten founder problem. The forgotten founder is someone who is part of the business in the early stages of the venture, but drops out. After the company goes through financing or is starting to pay off, this person comes back into the picture. Usually, the forgotten founder claims he had a substantial role in the company’s success and demands some form of payment. Snapchat, like many other companies, had to address this situation.

Equity: For co-founders, determining how to distribute equity may be one of the most difficult hurdles to overcome. More than half of startups fail due to co-founder disagreements and equity distribution can certainly lead to serious disagreements. For example, after more and more time passes, one founder may start to think they are doing most of the work and deserve more equity than others. She may think this is obvious and does not address it with others. Then, when the conversation finally happens, she finds out that the her co-founders disagree. If the group cannot reach an agreement, then the founder may walk away, which could lead to the dissolution of the start up.

Incorporation forces the equity conversation to happen sooner rather than later. In order to formally incorporate, the co-founders must establish and define the roles of each member, as well as the equity each receives. This is important in order to protect the company’s interests if disagreements arise later on. In regards to the example above, if a co-founder thinks that she deserves more equity, the company has legal paperwork that is enforceable and spells out what was agreed. In addition, having these documents may be able to prevent misunderstandings.

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Entity Selection for Startups: A Tax Perspective

The entity classification regulations under Internal Revenue Code section 7701, otherwise known as “check-the-box” regulations, allow startups to choose their classification for Federal tax purposes. Although the filing process itself is extremely simple (one simply checks the appropriate box, dates, signs, and submits the form), the tax implications of the choice of entity can be extremely significant.

This article will assist startups in choosing an entity by comparing and contrasting the tax implications of organizing as a C corporation, S corporation, or limited liability company (“LLC”). Sole proprietorships and partnerships will not be covered in this article as they do not provide full limited liability to owners, and other entities better meet the needs of most startups.

 

Startups that Expect Venture Capital Funding or Expect to do an IPO

The most significant tax feature of a C corporation is that it is taxed twice: first, the corporation is taxed on its net income, and then shareholders are taxed when they receive dividends. Though double taxation is unappealing, the first taxation layer prevents the corporation’s income from “flowing-through” to shareholders, which is why C corporations are the investment entity of choice for venture capital firms. Most venture capital firms raise money from tax-exempt entities, and if the firm invests money in a flow-through entity—such as an S corporation or LLC—then its tax-exempt investors would receive disadvantaged tax treatment.

If a startup plans on issuing shares through an initial public offering (“IPO”), then it should incorporate as a C corporation, as opposed to other corporate forms. An S corporation is unsuitable for an IPO because it cannot have more than 100 shareholders. LLCs are byproducts of state law, and thus it is extremely difficult to do an IPO of an LLC. Unlike a C corporation, which has unlimited life and free transferability, there is a risk that a LLC will dissolve when a member dies. Some states require all LLCs to dissolve after a set period of time. Furthermore, even if a LLC manages to become publicly traded, it will lose its status as a flow-through entity and lose it tax advantages.

In addition, if ownership interests in the startup will be provided to employees, tax law gives favorable tax treatment to incentive stock options (ISOs) granted by a corporation. An ISO holder does not have to pay taxes on the value of the stock options when she receives the options; the holder incurs tax liability only when the shares are sold. At the time of sale, the recognized gain is taxed at the long-term capital gains rate, which is more favorable than the ordinary income tax rate.

Thus, if the startup expects to receive funding from venture capital firms or do an IPO, then incorporating as a C corporation is the clear choice. However, choosing an entity becomes less straightforward in cases where venture capital funding or an IPO is not expected.

 

Startups that Expect to Initially Operate at a Loss or Distribute Current Earnings

As discussed above, S corporations and LLCs do not pay corporate tax because it passes income directly to its owners and investors. Because current earnings are taxed as ordinary income, startups intending to distribute current earnings and profits to their owners would avoid double taxation by organizing as a flow-through entity. On the other hand, if a startup expects to initially operate at a loss, then its owners will be able to deduct losses from their individual taxable income.

If a C corporation distributes current earnings, the amount cannot be deducted by the corporation except as salary (or other reasonable compensation) to shareholders who are also employees of the company. Thus, startups that expect to operate at a loss initially or to distribute current earnings should not incorporate as a C corporation. Instead, they should organize as a flow-through entity.

For startups that seek to build long-term value by accumulating or reinvesting earnings, other factors become more important. But in this case, since stock held for more than one year is taxed at the long-term capital gain rate—which is lower than the ordinary income rate—incorporating as a C corporation should be considered. Moreover, if a C corporation that qualifies as a small business corporation holds stock for more than 5 years, it will likely cut its capital gains tax rate in half.

As mentioned above, in certain cases there are tax benefits in organizing as a flow-through entity. Next, we will examine the implications of organizing as an S corporation versus an LLC.

 

Incorporating as an S Corporation vs. a LLC

As flow-through entities, S corporations and LLCs enjoy similar tax benefits. Neither pays corporate tax on earnings, and owners in both can deduct losses from individual tax returns. There are important differences, however, in ownership and formalities.

The IRS subjects S corporations to more restrictive ownership regulations than LLCs. First, S corporations can have no more than 100 shareholders, can only have one class of stock, and may not have non-U.S. citizens or residents as shareholders. Also, S corporations can only have one kind of shareholder: individuals. This limits startups that would otherwise consider raising capital from institutional investors. Comparatively, an LLC is unrestricted in the number of its members, can have foreign members, multiple classes of stock, and institutional investors as members. Therefore, LLCs are much less restricted in its ownership regulations. Additionally, LLCs can be incorporated tax-free for even more flexibility. For instance, after its owners and investors have deducted the initial startup losses, the LLC can incorporate in order to obtain funding from a venture capital fund.

Moreover, S corporations are corporations—which mean they must adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. LLCs, on the other hand, are not required to take any of these steps, although they are recommended.

Generally, because LLCs are flexible, require minimal formalities, and are easy to set up, any startup looking to establish itself as a flow-through entity should probably organize as an LLC,

 

Summary

Incorporating as a C corporation is recommended for startups that expect to receive venture capital funding or do an initial public offering. This explains the wide prevalence of C corporations on the West Coast, where venture capital funding is abundant. On the other hand, organizing as an LLC is recommended when startups expect to operate at a loss initially or distribute current earnings. Although S corporations are also flow-through entities, LLCs are generally better suited to startups because of the ownership restrictions and additional formation requirements for S corporations.

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Can I start a company if I’m in the US on a student F-1 visa?

Hands, 1

CPT or OPT programs may allow you to launch your startup while on a student visa.

America is great.

Because of the strength of the United States’ higher learning institutions it attracts a high number of international students a year, and the number is steadily increasing. Most students come from China and India, with the percentage of Brazilian students growing in sum each year.

According to a report by the Institute of International Education the U.S. was host to around 975,000 international students in the 2014-2015 academic year, up 10% from the previous year.

More students means more ideas, and of course more money. The Department of Commerce reports that international students added around $31 billion to the U.S. economy in the 2014-15 school year. One hundred and ninety-seven thousand of those students came to study business in the last academic year. At the University of Michigan students come from 114 different countries, with around two-thirds studying at the graduate level. Michigan Law is represented by 15 countries and full-time international MBA students at Ross make up 35% of the class total.

The F-1 Visa

F-1 visas are issued to international students if they are either attending an academic program or English Language Program at a U.S. university. There are varying requirements to hold this type of visa, but the gist is that you have to be taking a full course load and you can only stay in the U.S. 60 days after the completion of your program. The difficulty comes in the ability to work as an international student. Under this type of visa status students are not allowed to work off-campus during the academic year unless they face some sort of economic hardship and are authorized by their school to do so. However, they are allowed to work on-campus subject to certain conditions. After their first academic year F-1 students can engage in three different types of employment:

  • Curricular Practical Training (CPT)
  • Optional Practical Training (OPT) (pre-completion or post-completion)
  • Science, Technology, Engineering, and Mathematics (STEM) Optional Practical Training Extension (OPT)

Under these three categories F-1 students cannot work more than 20 hours per week, unless they are on break, then they are allowed to work up to 40 hours per week.

CPT

Curricular Practical Training (CPT) is a temporary authorization for employment. This means that the job has to be directly related to your major. CPT is a way for students to take part in internships and other modes of employment, including self-employment. CPT must be required by your degree program, or at the very least you must receive a number of credits for it. This type of employment must be done before graduation. If you accumulate more than 12 months of CPT authorization then you lose the ability to apply for OPT.

OPT

Optional Practical Training (OPT) is another type of work authorization that must be related to a F-1 student’s major. Whereas CPT is required by a student’s field of study, OPT is optional and you do not need to earn any credits in relation to it. OPT is not employer specific and may be done before or after graduation. According to the U.S. Department of Homeland Security “a student on OPT may start a business and be self-employed. The student must be able to prove that he or she has the proper business licenses and is actively engaged in a business related to the student’s degree program.” Students can generally do OPT for a period of 12 months.

The OPT STEM Extension

There is an exception under OPT for STEM students. However, the exception doesn’t apply to students who are self-employed or starting their own business.

Working vs. Owning

Poet and modern rap artist Jay-Z once crooned “I’m not a business man, I’m a business man!” And so I ask you, are you the owner or the employee? Let’s face it. No one wants to work for someone else anymore. Let’s call it the curse of Zuckerberg – and it’s as if every single millennial is affected by this curse. It’s likely why you’ve endeavored to build your own business.

There is a pretty important distinction to be made between working for and owning your own business in this discussion. If you are not part of the CPT or OPT programs then it is in fact illegal to work for an LLC, C-corp, or S-corp in the United States, even if it’s your own. I mean think about it. Why would the government see any difference between an F-1 student working for a large corporation like Coca-Cola and working for a 10 student strong start-up. Well, now that I’ve said it aloud there are an array of dissimilarities between the two, but that doesn’t change the fact that it’s still illegal. Although that doesn’t mean that an F-1 student cannot create an entity or hold shares in one. In fact, the U.S. does not require any founders in a (LLC or C-corp) company to be of American citizenship. S-corps do not allow for non-US citizen founders. So it all comes down to the type of work one does with the company and at what stage. If you are coming up with a name, filing trademarks, or forming an entity then you’ve done nothing illegal. However, once the entity is formed then things get a bit trickier. If you start to do any administrative tasks or employee like functions then you enter into a very gray area. Therefore, the best option (after entity formation) is for an F-1 student to enter into the CPT or OPT programs.

To Infinity & Beyond, the H1-B Visa

After graduation and after having been in the CPT and OPT programs students might want to consider obtaining an H1-B visa.

The H1-B visa allows employers to temporarily employ foreign professionals in specialty occupations within the United States. Specialty is defined as having a specialized knowledge in a certain sector or field. The most stringent requirement for a start-up is that one must have an employer-employee relationship with the petitioning U.S. employer.

According to the U.S. Department of Homeland Security “If you own your company you may be able to demonstrate that an employer-employee relationship exists if the control of your work is exercised by others.” This can be demonstrated by having a board of directors, preferred shareholders or investors – all of which show that your company controls the terms of your employment. Some evidence which demonstrates the distinction between your ownership interest and the right to control your employment includes:

  • Term Sheets
  • Capitalization Tables
  • Stock purchase Agreements
  • Investor rights Agreements
  • Voting Agreements, and
  • Organizational documents and operating agreements

The U.S. Government only gives 65,000 H1-B visas out each fiscal year. The first 20,000

petitions filed on behalf of beneficiaries with a U.S. master’s degree or higher are exempt from the cap. If your start-up is a nonprofit then you’re also exempt.

Good luck!

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Changing the Registered Office of a Michigan LLC

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Michigan has several economic development organizations that require startups to maintain an office in a certain city or vicinity in order to receive funding from that organization.  Some of these organizations will merely require that the startup maintain an office or a principal place of business in a certain location.  Others, however, will require that the startup’s “registered office” be in that vicinity.  This post: (1) explains what is a “registered office;” and (2) describes how to amend the location of your registered office for a Michigan LLC.

What is a Registered Office?

The Michigan Limited Liability Act (Section 207) requires Michigan LLC’s to maintain a “registered office.”  Simply put, this is the address where the state can send your company important information and assume your company received it.  The registered office is identified in Article IV of the company’s Articles of Organization, which are publicly available and filed with the state of Michigan.

Article IV Articles

We have previously discussed the Articles of Organization here.

It is important to note that the registered office does not need to be the same as the company’s principal place of business.  In fact, because many early-stage startups operate from work sharing spaces, incubators, or accelerators, the company’s principal place of business will, in fact, differ from the registered office (which will ideally be a more permanent address where the company is more certain to receive important state documents).  Many student entrepreneurs will use a parent’s permanent address (in Michigan) for the Michigan registered office.  Accordingly, before taking the time to change your registered office in your Articles of Organization, confirm that the funding organization does indeed require the registered office (as compared to a principal place of business) to be in a certain vicinity.

Amending Your Registered Office

If you determine that you need to change the registered office identified in your Articles of Organization, here is how to proceed.  The fee is $5, although expedited service is available for the higher fees described on page 3 of the Certificate of Registered Office (Form 520).

  1. Locate your ELF account number.  Or, if you have not set up an ELF account with the state of Michigan, do so.  This post discusses the benefits, and process of establishing, an ELF account.
  2. Complete the Certificate of Change of Registered Office (Form 520).
  3. Complete your MICH-ELF COVER SHEET, which will be filed along with the Certificate of Change of Registered Office (Form 520) that you completed in Step 2.
  4. Following the instructions which you received in the Response to your ELF Application, file the documents you completed in Steps 2 and 3 above.  As of the date of this post, ELF account filers may electronically file via email at cdfilings@michigan.gov.
  5. Filers without an ELF account may submit the above forms along with a check or money order to:

Michigan Filing Address

Once you have changed your registered office, understand that this is where the state will send important information, such as your annual statements.  If you change locations, and your registered office is no longer a valid mailing address for your company, you will need to use the above process to change the registered office identified on your Articles of Organization.

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LLC Formation: Why Filing Your Articles is Not Enough

While it might be simple to technically establish an LLC, several important documents are required to properly organize as a company with clear membership, governance, and IP ownership.

While merely filing Articles of Organization might be sufficient to establish an LLC, several important documents are required to properly organize as a company with clear membership, governance, and IP ownership.

Entrepreneurs are often attracted to organizing as a limited liability company (“LLC”) due to the perceived ease and cost-savings of formation.  In most states, one can (technically) establish an LLC by filing a single document and paying a small filing fee.  For example, in Michigan, one can establish an LLC by filing the Articles of Organization and paying a $50 fee.  While filing the Articles of Organization may technically establish an LLC, more is needed in order to properly organize an LLC.  This post examines the additional steps needed to properly organize a multi-member LLC.

Information Contained in Articles of Organization

The Articles of Organization are a simple one-page document that provide the following:

  • the name of the company;
  • the duration of the company, if other than perpetual (this is typically left blank for tech startups);
  • the name of the registered agent and address of the registered office;
  • the name of the “organizer” of the LLC.

Most states do not require any documentation other than the Articles of Organization (or that state’s equivalent publicly-filed document) in order to establish an LLC.

Information NOT Contained in Articles of Organization

Importantly, the Articles of Organization do not provide any of the following information:

  • who holds equity in the company;
  • how much equity any single person holds in the company;
  • who makes what decisions on behalf of the company;
  • what happens if a member leaves the company; and
  • who owns the IP created by members of the company.

At the most basic level, the absence of information about who is part of the company is particularly troubling.  If a founder does nothing more than file the Articles of Organization to set up a company, there is no conclusive document indicating who is part of the company.  Without more, individuals could point to vague oral or email statements to claim that they are entitled to some equity interest in the company.

Your State’s Default Governance Provisions May Not Be Appropriate

Most states have LLC statutes that provide default provisions for how LLC’s operate.  In the absence of additional documentation, such as an operating agreement signed by all members, these default provisions will control the operations of the LLC.  While it might be tempting to rely on these default provision rather than taking the time (and perhaps expense) to think through and establish company-specific provisions, founders should be wary of their state’s default provisions.  These default rules are unlikely to reflect exactly the way the founders intend to operate their company.  For example, in Michigan, section 450.4502 of the Michigan LLC Act provides that (unless otherwise specified in an operating agreement) each member is entitled to one vote in making company decisions.  In other words, even if interests in the LLC are divided 80/20 between two founders, they would each be entitled to one vote.

Additional Documents Needed for an LLC

The above deficiencies are why entrepreneurs should view LLC formation as requiring a suite of formation documents rather than the one-page Articles of Organization.  Specifically, a startup organizing as an LLC should use at least the following:

Operating Agreement – An Operating Agreement should be signed by all members of the Company.  Therefore, it confirms whether or not an individual is a member of the LLC, and how much equity that person holds.  The Operating Agreement should also specify at least: how decisions are made (e.g., what % of vote is required, and by whom, for the company to take certain actions); how membership interests can be transferred, if at all; and how profits/losses are allocated and/or distributed between members.  For most tech startups, it is common to create “Units” of membership interest (similar to stock in a corporation), which are established in the Operating Agreement.

Restricted Unit Agreements – If a startup seeks to impose “vesting” it is common to implement the vesting via a Restricted Unit Agreement entered into between the company and each individual member actively working with the company.  This prior post discusses the concept of vesting.  While the Operating Agreement may grant a member a certain percentage interest in the company, and the number of units that correspond to that percentage interest, a Restricted Unit Agreement will grant the company a repurchase option that lapses over time (i.e., the vesting schedule).  The Restricted Unit Agreement should be clear about specifying what action triggers the company’s repurchase option (for example, a termination of service, or a majority vote of the members of managers of the company).  Of course, whenever vesting is imposed (and the company’s repurchase option is less than the fair market value of the equity at the time of repurchase), holders of equity should pay attention to their 83(b) elections as discussed in this prior post.

Proprietary Information and Invention Agreement (“PIIA”) – PIIA’s should be signed by each individual member actively working with the company.  A PIIA assigns to the company rights in any intellectual property created by an individual during the course of their work for the company.  PIIA’s also include confidentiality obligations requiring the individual to maintain as confidential any of the company’s sensitive information.

IP Assignments –  If an individual (such as a founder) has been working on the startup prior to the company formation, then it is likely that individual holds intellectual property rights that need to be assigned to the company.  Because most PIIA’s are designed to cover intellectual property created during the course of an individual’s work for a company, they might not adequately cover pre-existing intellectual property.  Accordingly, IP assignments should also be used to cover any intellectual property created prior to company formation.

Proper Organization is Important Even for Startups Planning to Convert to a C-Corp

As discussed in this prior post on entity conversion, it is common for startups to initially organize as an LLC but later convert to a Delaware C-corp when they plan to raise capital from sophisticated investors.  For a startup contemplating this conversion, it might be tempting to forego the above organization documents, merely filing the Articles of Organization to establish the company as an LLC.  This is not wise, however.  Among other concerns, most state conversion statutes require a specified vote of the members in order to approve a conversion of an LLC into a Delaware C-corporation.  In MIchigan, for example, section 450.4708 of the Michigan LLC Act requires that all members approve a conversion unless the operating agreement provides otherwise.  Accordingly, absent an operating agreement, all members of the LLC would need to approve the conversion into a new corporate form.  However, absent an operating agreement, it is also difficult to conclusively know who is a part of the company (e.g., who the members are).  This lack of information would be ripe for an individual to later claim they were part of the LLC, but not included in the approval of the LLC to a C-corp.  Therefore, even when a startup is planning to convert from an LLC to a C-corp, they should first properly organize as an LLC so that the conversion process is clearly approved by a well-defined set of members under well-defined governance procedures.

Conclusion

With the above documents in place, it is now clear: which individuals are part of the company and how much they own; which members make what decisions on behalf of the company; that the company owns the intellectual property related to its business; and what happens if a member’s service for the company terminates.  None of this information would be clear if a startup merely files the Articles of Organization, and doesn’t take additional steps to properly organize itself.  Using the correct documents to properly organize will lessen the risk of potential disputes down the road, especially if the LLC later converts to a Delaware C-corp and seeks outside investment.

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Let Your ELF Help You File in Michigan

By setting up a Mich-ELF account, entrepreneurs can quickly and cheaply make their organizational filings in Michigan via e-mail.

By setting up a Mich-ELF account, entrepreneurs can quickly and cheaply make organizational filings in Michigan via email.

As addressed in this prior post, entrepreneurs in Michigan typically decide between a Delaware C-Corp and a Michigan LLC for their choice of entity.  With either choice, entrepreneurs should be aware of an easy electronic filing option in Michigan available by establishing a Michigan “ELF” account.  With an ELF account, startups seeking to organize as a Michigan LLC can quickly file their organizational documents via email.  Startups organized in Delaware, but transacting business in Michigan, will need to be authorized to transact business in Michigan as a “foreign entity” and can also file their application via Michigan’s ELF service.  This post serves as a guide to setting up, and using, one’s MICH-ELF account.

Establishing a MICH-ELF Account

To set up a Michigan ELF account, one must complete and submit a Michigan ELF application ( CSCL/CD-901).

ELF Application

To complete this form, one needs the following information:

1) Name, address and phone number of the MICH-ELF applicant

2) Fax number for return of document;

3) Type of credit card (VISA, VISA Electron, and MasterCard are accepted);

4) Credit card number, expiration date, name of cardholder, and billing street address and zip;

5) Contact person, phone, and fax number if other than applicant.

The completed ELF application should be faxed to (517) 241-6445.  Note that this ELF application should not be submitted with any other documents.  Your Articles of Organization or Application for Authority to Transact Business will be submitted in a separate filing after you receive your ELF filer number.  Michigan will reject your application if you submit your ELF application with other filings.

Questions Related to the ELF Application

Although the ELF application is relatively straight forward, some questions do arise.  One common question is who to identify as the applicant.  If one is organizing a Michigan LLC, there will not yet exist any entity when one is initially setting up the ELF account.  Nonetheless, Michigan customarily will accept the future company name as the applicant name.   Identifying a founder as the applicant is also acceptable.  For foreign entities, it is likely best to identify the foreign entity name as the applicant.  If you are an attorney filing an ELF application on behalf of the client, it is best not to list yourself as the applicant.  This is because when Michigan faxes your ELF account confirmation (see below), the only identifying information on the confirmation page will be the new ELF filer number and the name of the applicant.  If the applicant name is the attorney name, and that attorney commonly files ELF applications, there will no way to tie the confirmation page to a particular client without contacting the state.

For the contact person, it is likely best to identify someone who can quickly respond to questions from Michigan.  This will likely be the person handling this initial organization — either one’s attorney or a key founder.  Note that the contact person listed on the ELF application can be different than the Resident Agent that one will identify on their Articles of Organization.  So, the contact person is not signing up for any additional responsibilities on behalf of the company, other than questions related to one’s ELF account.

Your ELF Confirmation

Michigan typically processes ELF applications in less than 48 hours.  You will receive a fax from the state, similar to the following:

ELF Confirmation Page 2

It is important to store this document (or at least the ELF Filer Number), because one will need to include the ELF Filer Number in all future filings with the state.

Making Filings Using an ELF Account

An ELF Account permits one to make organizational corporate filings via email.  Corporate filings can be emailed to cdfilings@michigan.gov or faxed to (517) 636-6437.  Note that this is a different fax number from the one used to establish the ELF account.  A MICH-ELF cover sheet (CSCL-CD900) should be used with all ELF corporate flings.  The standard MICH-ELF cover sheet is shown below.

Elf Cover Sheet

Upon making an ELF filing, Michigan will automatically charge the credit card account associated with the ELF account.  Accordingly, it is important to update one’s ELF account when a business credit card is initiated.

Note that the ELF cover sheet is the only document that should include your ELF Filing Number.  Do not include the ELF Filing Number on the Articles of Organization themselves.  A common mistake is to for a filer to place their ELF Filing Number in the unmarked box on the right side of the Articles of Organization.  If you do this, Michigan will reject your filing and require that you remove the number.  Leave this box empty.

ELF Articles of Org

Conclusion

The Michigan ELF account process can save entrepreneurs time and money.  Email filings are simple and lead to more timely approvals from the State of Michigan.  Setting up your ELF account (and keeping your ELF Filer Number) can ease the headaches around organization, conversions, financings, or other occasions when timely filings matter.

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WhatsApp: What We Know About the Incorporation History of a $19B Company

Incorporated in California in 2009, WhatsApp, Inc. later converted to a Delaware corporation.

Incorporated in California in 2009, WhatsApp, Inc. later converted to a Delaware corporation.

As has now been widely reported, Facebook is acquiring cross-platform messaging app WhatsApp for a reported $19B.  The Wall Street Journal reports that this will be the largest acquisition of a venture-backed company in history.  While much has been written about this deal, it might be interesting to examine the corporate history of WhatsApp, Inc.  According to California’s records, WhatsApp originally incorporated in California on February 24, 2009.  While most startups seeking venture capital will incorporate as a C Corporation in Delaware, some startups will elect to form as an LLC or Corporation in their home state in order to avoid the extra fees associated with having to register as a foreign entity in the home state where they are transacting their business.  Because WhatsApp is based in California, WhatsApp likely benefited from incorporating in its home state because it did not have to register as a foreign entity in California and pay the associated fees on top of its Delaware fees.

As shown below, WhatsApp eventually converted from a California Corporation to a Delaware Corporation.

California records show that WhatsApp, Inc. incorporated in California in 2009 but later "merged out" into a Delaware corporation.

California records show that WhatsApp, Inc. incorporated in California in 2009 but later “merged out” into a Delaware corporation.

As described in this prior post, it is common for a startup to convert from an entity in its home state to a Delaware corporation if it seeks to raise capital from institutional investors.  Most venture capital firms can only invest in C corporations because of the negative tax and paperwork consequences to their limited partners of investing in a flow-through entity (such as an LLC or S corp).  Investors will prefer Delaware for a number of reasons, including that they are familiar with the protections provided to directors (which is relevant to venture capitalists because they will typically take a board seat) provided under Delaware law.

Delaware records show that WhatsApp became a Delaware corporation on July 16, 2013.

Delaware record show WhatsApp becoming a Delaware corporation in 2013.

Delaware record show WhatsApp becoming a Delaware corporation in 2013.

It’s been known that WhatsApp raised a Series A round of $8M from Sequoia Capital in April 2011. TechCrunch is now reporting that Sequoia also led multiple other major rounds in WhatsApp that had been previously unreported.

It is possible that WhatsApp’s conversion from a California corporation to a Delaware corporation was in connection with one of these rounds.  It’s also possible that WhatsApp’s conversion was part of preparations for a potential merger or other exit.  Rumors have swirled that in April 2013, Google and WhatsApp were in acquisition talks.

It is also interesting that no EDGAR results appear for Form D filings made by an entity named “WhatsApp.” Jason Mendelson and others have blogged about (and cautioned against) the perceived rationale for not filing a Form D, and the implications for a startup’s SEC exemption under Regulation D.

Perhaps we will learn more in the coming months about some of WhatsApp’s early legal decisions.  It appears to have worked out historically well for those involved.