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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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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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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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Re-allocating Equity in Your Startup

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

We have previously written about considerations for founders in splitting initial equity in their startup.  No matter how thoughtful founders are in dividing their initial equity, it is common for founders to realize after a period of time operating their company that their initial equity allowances do not accurately reflect the actual contributions or value from each team member.  Founders often believe they can simply create their own document redefining their split of equity %’s.  In the case of an LLC, founders often try to simply amend the cap table exhibit to their Operating Agreement.  While these steps are better than nothing, reallocating equity %’s involves transferring shares (for a corporation) or units (for an LLC) and therefore could trigger some tax and securities issues.  Additionally, it is important to generate clear documents, signed by all involved parties, in order to avoid later disputes over the number of shares/units held by individuals (especially when those shares/units hold more value).   Just as importantly, maintaining a clean and clear cap table is really important for early stage startups.  Investors will typically want to see clear documents showing the issuance from the company to each shareholder of shares that correlate to the numbers of shares indicated on the cap table.   This post provides a few specific methods for properly reallocating equity in an early-stage startup.  The specific approach will spend on the specific governance documents and circumstances for your startup, so please consult your attorney.  This post assumes a few important things:

  • the company is pre-financing and it can issue equity at a nominal valuation (in the case of a corporation, at or near par value of $.0001 or $.00001).
  • all stockholders are remaining involved with the company, in other words, no one is terminating an employment or contractor arrangement with the company.
  • the company’s board of directors (for a corporation) or board of managers (for a manager-managed LLC) are remaining the same.
  • the company has implemented standard vesting procedures for all founders (to learn more about vesting, see this primer on vesting.)

Calculating the Adjustment

The first step in reallocating equity is to figure out how much stock (for corporations) or units (for LLC’s).  Presumably, you have determined your new desired %’s.  You might think about your desired outcome in terms of %’s, but in order to get there, you need to think about the number of shares or units held by each individual.  For example, assume three individuals (Founders A, B, and C) currently own respectively 40%, 40%, 20% of the issued equity in a company, reflected by having been issued 2M, 2M, and 1M shares respectively.  They’ve decided to reallocate equity so that the three founders will own 30%, 30%, 40% of the issued equity respectively.

There are a variety of ways to achieve this outcome.

1) Issuing More Shares/Units to the Founders Desiring to Increase Their %.

For example, the company could simply issue Founder C more shares so that Founder C holds 40% of the new total.  In the above example, this would mean issuing Founder C 1,666,667 shares so that Founder A and B would still each own 2,000,000 shares and Founder C would own 2,666,667 shares and the equity would be divided 30%, 30%, 40% respectively.

When issuing more shares to Founder C, if the startup is a corporation, it would ensure it does not exceed the number of authorized shares in its Certificate of Incorporation.

The following documents would typically be used to execute the above:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,666,667 shares/units to Founder C.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,666,667 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.

2)Repurchasing Unvested Shares/Units from Founders Desiring to Decrease Their %.

Another way to reallocate equity using the above example, is to repurchase unvested shares from Founders A and B.  Using the above example, the Company could repurchase 1.25M shares/units from each of Founders A and B, so that they would each own 750,000 shares/units and Founder C would still own 1,000,000, providing the desired 30/30/40 split.  Note that repurchased shares go into the Company’s treasury (ie., as authorized but unissued shares).  They effectively disappear into the ether, which allows Founder C’s % to increase even though she maintains the same number of shares/units.

The following documents would be used to execute the above:

  • A Board consent (signed by all directors in the case of a corporation or managers in the case of an LLC) authorizing the company to repurchase 1.25M shares/units from each of Founder A and B.
  • Repurchase Agreements between the Company and each of Founders A and B.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

3) Combination of #1 and #2 Above.

Another way to reallocate equity in the above example would be to repurchase 500,000 shares/units from each of Founders and and B and issue 1,000,000 new shares/units to Founder C.  This would keep the number of issued shares/units constant at 5,000,000.  This method might be preferable if the startup didn’t have enough authorized but unissued shares/units to issue Founder C without repurchasing some from Founders A and B (making method #1 impractical because it would require amending the Certificate of Incorporation for a corporation), Founders A and B didn’t have enough unvested equity to repurchase the necessary shares/units (making method #2 above impractical), or the startup otherwise wanted to maintain the existing number of issued shares/units.

To implement this approach, the Company would use the following documents:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,000,000 shares/units to Founder C and the company to repurchase 1.25M shares/units from each of Founder A and B.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,000,000 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • Repurchase Agreements between the Company and each of Founders A and B where the Company repurchases from Founders A and B 500,000 shares/units each.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

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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.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 2)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 2 of a multi-part series.

This post discusses the scenario of a departing founder.  As explained on page 61 of Isaacson’s biography, within two weeks of organizing Apple, co-founder Ron Wayne made the decision to leave the company.  He sold the entirety of his partnership interest to the other co-founders, Steve Jobs and Steve Wozniak.  Ron Wayne’s motivation to leave Apple was in part due to the personal liability he would take on as a partner in a general partnership (as discussed in Part 1 of this series, Apple was originally organized as a general partnership).

The departure of a startup founder, however, may not always go so smoothly.  It is extremely common for founders to leave startups.  All too often, these founder breakups can be fatal to a startup.  According to Harvard Business School Professor Noam Wasserman, roughly 65% of the failures of high-potential startups are due to “people problems.”

There are well-known mechanisms, however, that make it possible for a startup to survive a founder breakup.  These include:

IP Assignments

All individuals working for a startup should sign documents assigning to the company any intellectual property created by that individual arising from their work for the company.  This is typically accomplished through a Proprietary Information & Invention Assignment Agreement (commonly called a PIIA).  This document should be signed by an individual at the beginning of that individual’s relationship with the startup.  Proper IP assignment language should include the words “hereby assigns,” so that the language will act to automatically transfer IP rights from the individual to the company upon the individual creating that IP.

If the individual has created IP related to the startup’s business prior to entering a formal relationship with the startup (such as a founder who has been working on an idea prior to incorporation), then that individual should also assign to the company that individual’s IP rights already in existence.

Restricted Stock Agreements Implementing Vesting

As discussed in this prior post, vesting refers to a company having the right to repurchase an individual’s equity if that individual’s service terminates.  The company’s repurchase option lapses over time.  Vesting is typically implemented through a Restricted Stock Purchase Agreement (for a corporation) or a Restricted Unit Agreement (for an LLC).

Departing Founder Example

Let’s pretend Departing Founder owns 25% of the common stock in a startup.  Departing Founder has a falling out with his or her co-founders.  Departing Founder has not signed any documents assigning IP to the startup and does not have a vesting schedule in place covering his or her common stock.  Upon Departing Founder leaving the startup, her or she will likely walk away with (at least) joint ownership of any IP to which Departing Founder contributed, and the full 25% of the company’s common stock.  The startup will not have any exclusive rights to the IP jointly-owned with Departing Founder.  In addition, 25% of the company will be dead weight, which will certainly be demoralizing to the remaining team members still working for the startup.  This startup is likely doomed unless it can work out an agreement with the Departing Founder to claw back the IP and equity.

Now let’s pretend the same situation exists with Departing Founder except that proper IP assignments and vesting schedules are in place.  Upon Departing Founder leaving, all IP will remain with the startup.  The Departing Founder walks away with no rights in the startup’s core IP.  Additionally, the startup will have the right to repurchase the unvested portion of Departing Founder’s 25% of the common stock.  For example, if vesting occurred over 4 years with a 1-year cliff, and Departing Founder left just after the 1-year mark, the startup would be able to automatically repurchase 3/4 of the common stock held by Departing Founder.  Departing Founder would remain a shareholder of the company, but only for the 6.25% of vested common stock (1/4 of Departing Founder’s 25% of the company).  The repurchased common stock would return to the company’s pool of authorized but unissued stock.  It would be available to incentivize the remaining workers, or more likely to attract the talent needed to replace Departing Founder.

Release and Termination

If possible, it is also wise to enter into a release and termination agreement with a departing founder.  While Ron Wayne is at peace with the fortune he would have had he not left the company, other departing founders might experience seller’s remorse and make claims against a company whose value skyrockets after a founder leaves.  Ideally, a startup and departing founder will  resolve any possibility that either startup or the departing founder could have any claim against the other in the future.

Returning now to the Apple situation, Ron Wayne desired to return all of his partnership equity to his co-founders.  This is likely an anomaly, though.  As discussed in our prior post in this series, most startup entities will provide limited liability to founders.  Accordingly, most departing founders will not have the threat of unlimited liability (present with a general partnership) to incentivize the departing founder to relinquish their shareholder or member status.  With the proper legal documentation — including IP assignments and equity vesting arrangements — startups can survive the departure of a founder.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 1)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters today, we thought it might be interesting to revisit Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple since its formation in 1976.  We can use these legal issues as a framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 1 of a multi-part series.

While Steve Jobs and Apple are known for thinking differently (as famously depicted in their 1997 “Think Different” ad), as a company, Apple has still encountered some of the same legal decision points common to today’s tech startups.  One example is the early choice of a form of entity for startup ventures.  On page 61 of the Steve Jobs biography, Isaacson explains that Apple’s three original founders — Jobs, Steve Wozniak, and Ron Wayne — established Apple as a general partnership.  Wayne wrote the partnership agreement, allotting 45% of the equity to Jobs, 45% to Wozniak, and 10% to Wayne, and requiring that expenditures over $100 receive approval of 2/3 of the partnership.

There are a few points to make here.  First, documenting these early agreements is a good idea in most cases.  It is important to note that in most states, a general partnership can be formed even without a written agreement.  The Revised Uniform Partnership Act defines a partnership as “an association of persons who carry on as co-owners of a business for profit.”  Therefore, if founders are working together in pursuit of a venture, they may be operating as a general partnership whether they know it or not.

Absent a written agreement, state law is going to dictate the specific equity and governance structure of the partnership.  This would be the same for other forms of entity as well, such as a limited liability company which is going to have an equity and governance structure imposed by state law in the absence of an operating agreement.  It is highly likely that this default equity and governance structure will not reflect what the founders have in mind.  So, put these agreements in writing — like Wayne did.  Unlike Jobs, Wozniak, and Wayne it is also wise to consult an attorney familiar with startups who can also establish industry standard mechanisms such as vesting.

Second, today, selecting to organize a tech startup as a general partnership would be highly irregular.  The reason is that in a general partnership, each partner is responsible for the liabilities of the company (whether or not that partner was involved in any way with the actions underlying the liability).  In other words, an individual partner in a general partnership could incur catastrophic liability through no fault of their own.  Accordingly, almost all tech startups will organize in a form of entity providing limited liability to the owners — typically a limited liability company, an S corporation, or a C corporation.   This prior post addresses the entity selection question for startups.  Indeed, according to its website, Apple incorporated on January 3, 1977, within a year of its initial organization as a partnership.

In fact, the threat of personal liability is one of the reasons for Wayne electing to leave the Apple partnership shortly after its formation.  According to Isaacson’s book, Wayne became worried about his personal liability for Apple’s debts when Jobs began planning to borrow money to grow the company.  He sold the entirety of his partnership interest to Jobs and Wozniak for $2,300, as reported in Isaacson’s book and by Wired Magazine.  We will talk more about legal issues associated with departing founders in our next post in this series.