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Why Outside Advisors are Critical For a Startup’s Growth and Success

Many startup founders of young companies fall into the same trap: they insulate themselves and just talk to family, friends, colleagues, and co-founders (if any) as a sounding board to bounce off business ideas and make decisions. While it’s easy to see why this approach is tempting, bringing on outside advisors early on who are not major investors or family members are integral part of a startup’s success.

A common way is to bring on outside advisors through an advisory board. A board of advisors is not a formal legal entity like a board of directors, which means that they can’t fire you or have control of your startup. Still, they can partake in regular board meetings as well as providing advice or mentoring on ad hoc basis. These are individuals who have certain knowledge that can be valuable to a startup. For one startup, that advisor may be a finance professor, a marketing expert, a software engineer, or an operations guru. For startups, advisors are generally compensated for their advice through stock or stock options in the company, although there can be other considerations for their time.

Notwithstanding the many benefits that come with onboarding a board of advisors, you should only bring them on if you are going to listen to their feedback. If you’re just looking to retain positive feedback while dismissing advice that potentially challenges your ideas, you’ll be wasting everyone’s time, including your own.

  1. Advisors will ask critical questions and challenge ideas: Consider the following scenario. You have a great business development idea and your co-founders and the team is pumped by the possibility. Who is tempering the enthusiasm? Who is there asking critical questions or challenging the business pipeline? If the answer to this is “no one besides the leadership team,” these ideas can become circular, unfeasible, and unchecked. Outside advisors who care about your idea can help sharpen your thought process and help fill the gaps in your business strategy. These are people who are willing to ask critical questions and offer complementary skills to the founders. This results in diversity of opinions.
  2. Advisors can help you build connections and relationships outside the entrepreneur world: Founders are often surrounded by other founders. Advisors have years of experience under their belt and in addition to providing an outside perspective, they can connect you to people outside your industry. For example, student-led startups can leverage their relationship with outside investors and meet experienced entrepreneurs, venture capitalists, and industry experts. Establishing common relationships through outside advisors will broaden your network.
  3. Startups need outside investors for future capital raising: Post angel investor and seed rounds, third party investors will look to see whether a startup has a few outside advisors, often in the form of an advisory board. If a startup has outside investors who have specific industry experience and seems invested in the company, it can serve as a market validation to potential investors. Further, outside investors can help you prepare for robust business milestones and successfully pitch to get more capital. They can also help you weigh in your funding options, evaluate growth plans, and carry your company forward.
  4. Advisory Board vs. Board of Directors: The board of directors is the central governing body for your startup. For small startups, founders serve as directors and don’t consider bringing in outside board members until the company took on significant investment. As previously discussed, the board of directors is legally bound to the business and therefore has a more serious engagement, because they carry potential liability associated with being part of that board. The board of directors has legally defined responsibility and is governed by the corporation’s bylaws; since directors are elected for established terms they are more difficult to remove. In contrast, a board of advisors can be more informal and flexible. It’s essentially a team of people appointed to guide and counsel founders and their startup. The board of advisors has no fiduciary duty to the company and because they carry less liability than directors, less compensation is required to retain an advisor.

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Why Do Technology Startups Need IP Assignment Agreements?

If you are considering forming a startup, an intellectual property (IP) assignment agreement will be crucial for your company, especially if your company wants to get financing from outside investors in the future. An IP assignment agreement is a contract that transfers an individual’s rights to an intellectual property (for example, patent, trademark, copyright, etc.) to another legal entity, such as a company. You and your colleagues may want to ask: why do you need to transfer your intellectual property rights to your company?

 

What are the consequences for not having an IP assignment agreement?

If individual inventors do not assign the IP rights to the company, it will be very difficult for the company to seek investment in the future, because an investor will not fund a company that does not have the complete ownership of its intellectual property assets. Therefore, the IP assignment agreement will be a key document that the investor will look for before deciding whether she will fund the company.

Imagine two inventors jointly own a patent. An obvious concern for potential investors is whether this patent can be effectively protected against infringement. However, if the patent is involved in patent infringement litigation, both co-owners must join the lawsuit so that the suit can be filed. Either owner’s lack of interest in joining the litigation will make the patent meaningless because the patent can be easily infringed. In contrast, if a sole owner, the company, owns the patent, the company itself can bring this suit. This is easier for protecting the patent because the company does not need to get every owner’s consent to bring the suit.

Additionally, the value of the patent will be diluted if it is jointly owned by several owners. Each co-owner of the patent can independently exploit, without consent of, and without accounting to, the other co-owners. Because a license is available from more than one party, its value is inevitably diluted. Otherwise, if a potential licensee wants to get an exclusive right to the patent, it must negotiate with all owners, and the holdout problem (where one party’s withholding of support prevents a deal) is likely to occur.

 

What provisions need to be included in an IP assignment agreement?

Because the IP assignment agreement is critical to a company, the agreement should be drafted by a lawyer. Both the Assignor (e.g., the individual developer) and the Assignee (e.g., the company) must carefully review the provisions in this agreement. The most important sections of an IP assignment agreement are:

Assignment of Intellectual Property. This section describes the assignment and acceptance of the intellectual property. If the Assignor agrees to assign the intellectual property in exchange for a consideration, either in the form of cash, equity or royalty, the consideration needs to be clearly identified in the agreement.

Description of the Assigned Intellectual Property. The agreement usually includes a full description of the intellectual property or refers to an exhibit that describes the intellectual property. Notably, the to-be-assigned intellectual property sometimes includes goodwill, which is the intangible value of the intellectual property. The assignment of trademark’s goodwill is particularly important because it includes the brand’s reputation and recognizability.

Warranty. It is especially important to have the Assignor warrant that she has the capacity to assign the intellectual property. Otherwise, the assignment may not be effective.

An IP assignment agreement is crucial for showing your startup’s future investors that the company possesses valuable intellectual properties. Therefore, soon after your company is formed, remember to ask everyone who may have a right in the intellectual property, including inventors, employees, independent contractors and so on, to sign the IP assignment agreement.

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Forming an LLC: Member-Managed or Manager-Managed?

After considering advantages and disadvantages of different forms of an entity, you have now decided that forming an LLC (limited liability company) would be the best option for your company. However, you have to go through one more step to be completely done with the entity selection process: Should you form a member-managed or manager-managed LLC?

Basically, you may choose one of two different management structures for an LLC: Member-managed vs. Manager-managed. Member means an owner of an LLC in this context. In Michigan, the default management structure of an LLC is member-managed, as is the case in most other states. However, you may choose to form a manager-managed LLC instead by designating it in the Operating Agreement.

 

Member-managed vs. Manager-managed LLCs

Member-managed LLCs:

If you choose to form a member-managed LLC, all members have an equal right to participate in managing and operating the company unless the operating agreement states otherwise. A member-managed LLC essentially leaves no room for outsiders to jump in and interfere. Consequently, a member-managed LLC allows every member to vote in the decision-making process and enter into binding agreements and contracts on behalf of the company as its agent. However, members may choose to form an LLC with different classes of members where one class would have a different level of rights than the other classes. Also, the operating agreement can limit the scope of authority that each member has in a member-managed LLC. For instance, the operating agreement may require a majority or unanimous vote of members to make certain business decisions such as contracts and loan agreements.

Member-managed LLCs also do not have boards of directors unlike manager-managed LLCs. Also, member-managed LLCs tend to be more cost-effective than manager-managed LLCs due to their decentralized management structure.

Therefore, a member-managed LLC could be a better option for you if every member of your company wants to play an active role in running the business. However, a member-managed LLC also has some downsides due to its management structure: 1) it might be inefficient if the company is too large or complicated for all members to take a part in managing and operating the business; 2) it can also turn out to be inefficient if some members are not well-versed in business management; and 3) the expulsion of a member could be difficult since it would require an unanimous approval of all the other members unless specified otherwise in the operating agreement.

 

Manager-managed LLCs:

On the other hand, manager-managed LLCs have one or more managers to manage the company and arrange business affairs on the company’s behalf without getting the members’ consent or approval first. Only designated managers have the authority to make determinations on behalf of the LLC in manager-managed LLCs. Thus, manager-managed LLCs have a more centralized management structure and enable the company to be managed more like a corporation. For this reason, manager-managed LLCs would be preferable if your company is large and complex, since getting all the members together to vote and make decisions as a whole could be inefficient for large companies. Hence, a manager-managed LLCs would streamline the decision-making process and enable members to focus more on works of their choice in such cases.

Members may select one or more of the members as managers of the LLC, or they may hire professional managers who are not members of the LLC but have adequate expertise and qualifications. Having professional managers with experiences in business management can also be beneficial for your business in terms of protecting the company’s interest, attracting investors, and protecting the investors’ money. The members may specify details such as the number of managers, required qualifications, and resignation procedure in the operating agreement.

Since manager-managed LLCs allow managers to make decisions on behalf of the LLC without acquiring members’ consent first, this management structure would be more suitable if members of your company wish to take a more passive role. For instance, if some members of your company are investors and do not want to get involved in day-to-day management of the company, manager-managed LLC could be a better option for your company. If members of your company wish to select some of the members as managers, it would be advisable to designate more active members as the company’s managers. Members who are designated as managers may also receive a separate compensation as an employee.

 

Fiduciary Duties

Members of a manager-managed LLC as well as managers of a manager-managed LLC, including both professional managers and members who have been designated as managers, owe fiduciary duties to the LLC. In Michigan, a person who manages an LLC does not owe fiduciary duties to the members of the company. Fiduciary duties mean duties of trust that mandate people who owe such duties to place the company’s interests above their own or other parties’ interests. However, the members may agree to waive some fiduciary duties by specifying that in the operating agreement.

The two most important types of fiduciary duties owed to an LLC are 1) the duty of loyalty and 2) the duty of care. A person who owes the duty of loyalty to an LLC is expected to place the company’s interests above his or her personal interests and goals. He/she also needs to conduct any transactions and deals on behalf of the company in good faith. Also, he/she must not compete directly with the company or take advantage of the company’s internal information, commercial activities or business opportunities in an inappropriate manner to earn secret profits.

On the other hand, the duty of care requires one to act prudently in good faith and exercise reasonable care when performing their work on behalf of the company. If a member of a member-managed LLC or a manager of a manager-managed LLC makes a business decision with negative consequences for the company, that person would be protected from liability as long as he/she made the decision in good faith and exercise reasonable care during the process.

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How to Split Up Equity Among Co-Founders (and Why You Should Care)

You started a company with a couple of your good friends. Some have put in more money or time than others, but you feel like you can trust each other. That’s why when it’s time to formalize the business and raise money, you all come to the non-confrontational answer of how to split up the equity: equal ownership for everyone. It’s simple, seems fair, and avoids any awkward debates. But does it really make sense?

The answer is likely to be “no”, although it’s what many startups do. While splitting equity evenly is a good way to avoid an awkward discussion today, it may set you up for failure further down the road — when the stakes are higher.

 

The Dangers of Splitting Up Equity Equally

Prospective investors will be skeptical when they hear that there’s an even-split. They will want the equity split to determine each team member’s level of contributions and commitment. If the split doesn’t match the respective contributions and commitment, the team is not going to be incentivized appropriately to get the job done. Investors are especially wary of uncommitted founders that try to exert a disproportionate influence but don’t meaningfully contribute to the startup’s success.

It may reflect upon the team’s ability to run an effective startup, as well. Investors may be inclined to think the founders are not sophisticated enough to know what type and level of contribution it will take by each member, based on his or her role, to grow the business. Worse, they may just write off the startup as being unprepared to discuss the question of equity, chalking it up to the founders being hesitant to tackle tough issues.

At the very least, if you’ve decided to go with an even-steven split, you should be prepared to explain your reasoning (read on for guidance on that).

The other reason the split should be more thoughtful is more obvious: things can (and will) change. Your co-founders may already have insight into their respective future commitments and how much effort they can realistically put into the startup’s success. The startup may require more work than one of the co-founders wants to put in, leading them to tap out early. At that point, a tense conversation may ensue and it will likely be harder to change the split – leading to legal headaches, tax issues, and strained relationships.

 

How to Split Up Equity

There’s no one magic formula to get this right. The best strategy is to have an honest discussion up front about what each of you bring to the table. The evaluation should cover the following:

  1. Experience

Equity splits should take into account background experience relevant to the startup that will be essential to its success going forward. Also, more senior members may have a larger founders’ equity percentage than more junior co-founders, since they’ve put in more time before others joined at later stages. This leads us to….

  1. Sweat Equity

In return for helping to start the company, co-founders might forgo salary early on to earn an additional share of “sweat” equity. The split should reflect how much time and effort a co-founder has (and will) put in, and what the monetary value of that effort looks like relative to other team members.

  1. Capital Investment

Founders may have put in capital to fund the startup. Those who put in more than others may be compensated by receiving a larger portion of founders’ common equity as a result, rather than structuring their investment as debt or some type of separate investment instrument, like preferred equity (making them akin to venture capital investors). This factor should be closely assessed with future commitment to the company.

  1. Future Commitment / Role

The equity split should reflect the on-going involvement of the co-founders in the company. One or more of the co-founders won’t be involved on a full-time basis going forward. Those co-founders that are there for the long haul and working full-time should have a multiple-times larger chunk of equity.

Note that earning equity as a co-founder should always be contingent upon staying with the company for a certain amount of time – called a vesting period – typically four years. This incentivizes co-founders to stay on and build out the startup. If they depart early, they’ll only get whatever equity they have earned up until that time

  1. Role in Ideation

The ones who came up with the idea and / or created the IP behind the startup may request more equity. However, it may be wiser to value execution of the business over the initial idea. That’s why we recommend focusing more on sweat equity and future commitment; that being said, most discussions will involve how to make sure the person who came up with the idea gets a fair share.

It’s OK to split up equity evenly – so long as there is sound reasoning behind doing so. It’s not necessarily one of the first decisions you must make, although earlier is better. If you still need time to figure out how the above criteria will pan out, think about putting a stake in the ground with a rough estimate of equity splits (or even equal split), but also set aside an equity “pool” (say, 25%) to allocate down the road if things change or to correct an inequity that might happen should one of the founders underperform or excel beyond the others.

More resources

  • Check out this piece at Quartz on the Slicing Pie model for splitting equity
  • Consider the equity calculators on Gust and Foundrs.com, or the spreadsheet from Founder Institute. These tools help you determine how to split up equity based on several factors (commitment, ideation, pay, etc.)
  • The Zell Lurie Institute at the University of Michigan Ross School of Business has experienced faculty and staff members who can help if you’re a student entrepreneur. You can request an appointment to speak to a representative here.

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Dividends — Who Cares?

When a startup seeks financing, at some point the topic of dividends may come up. It seems everyone has heard of dividends, but who really cares about them? Generally, dividends are not as important as many of the other term sheet provisions, but you may encounter an investor who gets hung up on them (private equity types love dividends, while venture capitalists typically couldn’t care less). Why?

First, what is a dividend? A dividend is a distribution of the company’s cash or stock to its shareholders. Seems simple. But, naturally, lawyers have made it more complicated than that. For example, there are cumulative and non-cumulative dividends. With a non-cumulative dividend, if the company does not declare a dividend during the fiscal year, then the right to the current dividend is relinquished. On the other hand, with a cumulative dividend, the right to receive the dividend is accumulated until it is paid or terminated. This all sounds important, but in reality, early-stage startups rarely have any cash to distribute, and stock dividends lead to dilutive problems.

Dividend language may look something like this:

Series A Preferred Stock will carry an annual [insert dividend percentage, typically in the range of 8%]% cumulative dividend [compounded annually] of the Original Purchase Price in preference to any dividend on the Common Stock payable upon a liquidation or redemption. For any other dividends or distributions, the Series A Preferred Stock will participate with Common Stock on an as-converted basis.

So why am I questioning the importance of dividends? Because dividends cannot provide the type of return that venture capitalists are looking for. This can be shown by doing some easy math. Assume a dividend of 10% (dividends typically range from 2.5% to 15%, depending on the investor – using 10% keeps the math easy). Venture capitalists are typically swinging for the fences, not trying to generate returns for their investors from their companies cashflow. A successful return in a VC’s mind is likely closer to 10x her investment, not 10% per annum.

Assuming your VC receives a favorable 10% automatic annual cumulative dividend (without the compounding aspect to keep the math simple), it would take the VC 100 years to get her 10x return through the dividend. With a 10% dividend, a VC will only get 1x her investment if she holds the investment for 10 years. In general, a venture deal has a 5 to 7-year lifespan; with a 10% automatic annual cumulative dividend, the VC will never reach the 10x return from the dividend alone.

When can a dividend matter? Dividends can create and build an internal rate of return on an investment that will be realized upon redemption or exit through sale or an IPO. In other words, a dividend can provide downside protection to the investor. Let’s consider a $50M investment with a 15% cumulative dividend that is acquired after three years for $100M. If we assume a straight (or non-participating) liquidation preference and that the investor received 33.3% of the company for her investment (a $150M post-money valuation). Because the $100M sale price is less than the $150M post-money valuation at the time of the investment, the investor will use her liquidation preference to receive her original $50M plus any accrued dividends. In this case, the accrued dividends, assuming they were accumulating and not being paid, would be $22.5M ($7.5M per year for 3 years). Here, if the VC did not have a dividend, the VC would have foregone an additional $22.5M to protect this (losing) investment.

Well if a dividend provides downside protection, then why wouldn’t it be an important provision? Because we are assuming the company can or should actually pay out a dividend. As mentioned above, dividends can be paid out in cash or stock, usually determined by the company. If the dividend is paid out in stock, it leads to additional dilution of ownership. If the dividend is paid out in cash, it might be depleting the company of necessary resources.

An automatic dividend can also cause significant trouble for the company. It’s important to include any automatic dividends in a solvency analysis, as an automatic cumulative dividend could unknowingly thrust you into insolvency.

Many VC’s recognize that by insisting on receiving a dividend, they may actually lower their return on investment by sucking the company dry. Dividends are more common in private equity investments because the investment amounts are typically larger (typically greater than $50M) and less risky. The larger the investment and the lower the expected exit multiple, the more a dividend comes into play.

If an investor insists on receiving a cumulative dividend from your early-stage startup, know that the investor might not have your growth as a high priority. Make sure you do the math and understand how the dividend may impact your piece of the pie upon an exit. And just because everyone has heard of a dividend, doesn’t mean every company should be offering one.

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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.