FORMING A NEW BIOMEDICAL COMPANY

The Legal Basics

Biotechnology Interest Group (BIG)

South Carolina Clinical and Translational Research Institute

David L. Wilke & Jason S. Wood

Wyrick Robbins Yates & Ponton LLP

ENTITY SELECTION

FOUNDER STOCK/GOVERNANCE

INTELLECTUAL PROPERTY AND LICENSING

SUPPLEMENTAL MATERIAL:

EARLY STAGE FUNDING

2

AGENDA:

ENTITY SELECTION

3

Forms of Business Entities

• Sole Proprietorship• General Partnership• Limited Partnership• Corporation• C corporation• S corporation

• LLC

4

Key Factors to Consider In Choosing a Form of Entity

• Personal liability protection

• Tax considerations

• Management and governance structure

• Need for outside investment

5

Corporation• Shields owners (stockholders) from liability

• Board members have fiduciary duties, however• Regimented organizational/management structure

• Articles of Incorporation/Bylaws• Shareholders/Directors/Officers

• Flexible capital structure and transferability of ownership• State of incorporation is important

• Delaware is the leader• Tax treatment:

• S corp: Pass-through tax treatment• C corp: Double taxation• Converting into an LLC can trigger adverse tax

consequences

6

Limited Liability Companies• Shields owners (members) from liability (like

corporation)• Management/organizational/economic structure more

flexible than corporations• Typically, more direct control retained by

owners, but can structure around this• Members/Managers• However, can structure governance like a

corporation (Board, officers, etc.)• Pass-through entity for tax purposes• Can usually convert into a corporation without

adverse tax consequences

7

Entity Comparison on Key Drivers:

C corp S corp LLC

Tax Treatment

Subject to tax at corporate and shareholder level (“double taxation”)

Pass-through (no corporate tax)

Pass-through (but FICA and no fringe benefits for members)

Ownership Limitations

Virtually no limits ≤ 100 shareholders Only individuals, certain trusts, and other S corps (may preclude investment)

Virtually no limits (although difficult for VCs and non-profits to hold interest)

Capital Structure(Equity Rights/ Preferences)

Flexible – can have multiple classes with differing voting and economic rights

Only one class of stock (though can have voting and non-voting stock)

Flexible – although customary stock options can be a problem

S automatically converts to C when disqualified

8

SBIR/STTR Requirements for an Eligible “Small Business”

• Organized for profit business• At least 51% owned and controlled by

individuals that are U.S. citizens, permanent residents

• Located in the U.S.• 500 or fewer employees• Above apply regardless of choice of entity

9

Which Choice is Right for Me?

Since liability protection is similar, often comes down to:• Desired tax treatment• Type of business• “Lifestyle” business?• Owner involvement – active or passive?• Employee incentive equity important?

• Growth and/or exit strategy• Growth business? Internally or externally funded?• Income stream?• IPO/sale of the company likely?• Structure for multiple business lines?

10

Which Choice is Right for Me?

Each situation is unique, but generally…• If require significant outside money for

growth – C corp

• If small, income generating venture – S corp or LLC

• If university is to take an equity interest – C corp

Most life science ventures will be C corp

**Bottom line: Consult knowledgeable attorney and accountant to analyze

and discuss the specific facts presented **

11

FOUNDER STOCK/GOVERNANCE

12

Founder StockWhat is “Founder” Stock? - This is equity granted to founders of the start-up, typically at a very low price (par value).

Restricted v. Unrestricted - Restricted stock is subject to vesting, unrestricted is not. If founder leaves for any reason, company can repurchase unvested shares at cost.

Vesting – Investors will require, but still good idea for founder team pre-funding. Typically some portion can be vested up front, with remainder vesting over 3-4 years.

13

Founder Stock(Continued)

****Beware of Tax Impacts of Founder Stock Subject to Vesting****

If founder terminates service prior to all shares vesting, Company can repurchase the unvested shares at cost – this creates a “risk of forfeiture” that triggers special treatment under Section 83(b) of the federal tax code.

• If founder makes a proper Section 83(b) election (within 30 days of purchase), then:

• there is typically no ordinary income tax when the founder stock is issued (since they pay fair market value (FMV) for those shares); and

• founder gets capital gains treatment on all appreciation in value at time of sale of shares.

• If no proper Section 83(b) election is made:• as shares vest (and risk of forfeiture lapses), founder taxed at

ordinary income rates on difference between FMV of vesting shares and original cost basis. Shares typically illiquid, so cannot sell them to pay this tax; and

• founder gets capital gains treatment on all subsequent appreciation in value at time of sale of shares.

14

GovernanceBoard of Directors Keep small for start-up, but never too early

for knowledgeable independent directors

Election determined by stockholder agreement

Officers CEO/PresidentSecretaryTreasurerAssistant Secretary

Stockholders Certificate of IncorporationBylawsStockholders/Voting Agreement (buy/sell, ROFR/co sale, drag along, tag along, etc.)

Scientific Advisory Board Provide expertise and guidance to Board and managementNo fiduciary duties, but should agree to confidentiality and assignment of inventions

15

INTELLECTUAL PROPERTYAND

LICENSING

16

What is Intellectual Property?

• New or original ideas, information or technology• Patent – the right to exclude other from making, using

or selling an invention• Trademark – any word, symbol or device used in

commerce as an indication of source for products or services

• Copyright – protects the right to copy, distribute, sell, publicly perform or display, or make derivative works of an original work of authorship fixed in a tangible medium of expression

• Trade Secret – information that is (1) valuable or creates a competition advantage, (2) protected by reasonable efforts to prevent disclosure, and (3) not known by others

17

Common Types of University Technology

• Chemical compounds• Biological products (peptides, antibodies, cell lines)• Diagnostics (assays, genetic markers, imaging devices)• Animal models• In vitro assays• Mechanical/electronic devices• Materials• Software

• Combination of potentially patentable technology, copyrightable work and trade secret

• May not be worth seeking (or paying for) patent protection• Cost• Uncertainty of enforcement• Speed of product/market evolution

18

Patents• Three basic requirements:

• Utility (useful) –supporting data usually submitted to show therapeutic utility

• New – “first to invent” (U.S.) v. “first to file” (most foreign)• Nonobvious

• One year statutory bars for proving novelty (only U.S.):• Offer for sale• Publication• Public knowledge (disclosure) or use (demonstration)• Inclusion in previously issued patent

• Term• 20 years from filing

• Costly ($1,000s to $10,000s)• Owned by inventor unless rights assigned by contract (they

usually are!)

19

Trade Secrets• A trade secret is any information that is

• Valuable or provides a competitive advantage;

• Protected by reasonable efforts to prevent disclosure; and

• Not known by persons other than the owner.

• Companies protect trade secrets by requiring employees and consultants to sign nondisclosure agreements and by taking other protective security measures (locked filing cabinets, areas with restricted access, etc.)

• Information is entitled to trade secret protection for so long as such information retains its status as a trade secret

• Keep it secret!

20

How Do You Protect Your IP?• “Perfect” Your Rights

• Patents – File with PTO• Trademarks

• Common Law• Registration – File with PTO

• Copyright• Common Law• Registration – File with Copyright office

• Trade Secret – Keep it a secret• Contractual Protection

• CDAs/NDAs/MTAs• Employment/Consultant Agreements• Appropriate provisions in all contracts (sponsored,

research, contract research, CRADA)• Enforcement is costly

21

Licensing University IP• Assume any technology developed by university

faculty/personnel is owned by the university

• Stakeholders: institution/technology transfer office, inventors, licensee/management, investors, acquirors and strategic partners

• Early and open dialog with technology transfer office

• University inventor should be part of the process

• It can take a long time

• Involve counsel or entrepreneur with extensive university licensing experience before discussing specific terms

22

What Does the Institution Want?

• Advance Science and Its Educational Mission• Benefit Society• Technology/Product to Market• Create Jobs/Economic Development

• Direct Economic Return• Cover Patent Costs• Subsidize Research Activities• Reward/Retain Active/Entrepreneurial

Faculty

23

What Does the Licensee Want?

• Technology/Product• Freedom to Execute and Evolve• Change Business Plan• Strategic Partnerships• “Exit” (eventual IPO or sale of the

company)• Economic Return

24

What is a License?• The right or authority to use someone else’s

property or exercise someone else’s rights

• In the case of technology developed at an academic or non-profit institution, that means the right, under intellectual property rights owned by the institution, to use and/or exercise such rights

25

Anatomy of a License• License Grant: What are you getting? What

can you do with it?

• Payment Obligations: How much does it cost? (and when?)

• Diligence/Performance Obligations: How do you keep it? (How can the university it get back?)

• Patent Prosecution and Infringement Provisions: Who’s in control?

26

Typical University Start-Up License

• Exclusive patent rights (sometimes field limited)

• Equity (common stock) with antidilution protection

• Single digit sales royalties

• Sharing of sublicensing revenue

• Reimbursement of patent costs

• Milestone payments

• Diligence milestones

• The devil is in the details – the “standard form” almost always requires negotiation to minimize barriers to investment, strategic partnerships, and/or sale of the company

27

So what does this all really mean?

• Make sure the company has the IP it needs• License from university or corporate source• Assignment from individual inventor/founder

• Keep things confidential - control access• Use NDAs/CDAs/MTAs

• Use good contracts whenever IP might be involved• Every founder, employee and consultant should sign an

agreement assigning IP to the company• IP is (almost) always involved• Don’t assume the company owns IP created on its behalf

• Start-ups should use IP counsel early and often (but judiciously)

28

EARLY STAGE FUNDING

29

Early Stage Funding Model

1. Discovery alone typically not enough for VC

2. Need proof of principle – Animal models, prototypes, etc.

3. Technology “Incubating” longer these days

4. Must obtain sufficient Early Stage Funding to bridge to VC

30

Early Stage Funding Opportunities

• Local, State and Federal Governmental Programs (Like SBIR)

• Private Foundations and Public/Private Sector Initiatives

• Personal Resources; Friends and Family• High Net Worth Individuals (“Angels”)• Small Venture Funds• Venture Capital Funds• Strategic and Collaborative Partners and Licenses

31

Early Stage Funding Opportunities

Governmental ProgramsSBIR/STTR (NIH, DOD, etc.)

Direct Federal Grants

State Matching Programs and Tax Credits

32

Early Stage Funding Opportunities

Private Foundations and Public/

Private Sector Initiatives1. Research Foundations: - Typically (but not always) targeted therapeutic areas

Examples:

Cystic Fibrosis Diabetes

Parkinson’s Disease Schizophrenia

Cancer Blindness

2. SCRA/SC Launch! Grants/Loans

33

Early Stage Funding Opportunities

Personal Resources (Friends & Family)1. Your own money: “Skin in the Game” (not

just sweat)

2. Friends, family, business relationships• Only amounts they can afford to lose• Silent partners or, if not, direct industry

expertise• “Accredited” (high net worth)

individuals• Stockholders Agreement

34

Early Stage Funding Opportunities

High Net Worth Individuals (“Angels”)State of Angel Investing – Impact of 2009 Capital

Market Crisis

Organized Angel Networks

Angel Investors – What to look for?•Industry expertise•Can afford to lose money•Personal interest (therapeutic area?)•Connections to other capital, industry-specific relationships•Small number

35

Early Stage Funding Opportunities

Angel Investing Pitfalls/Red Flags1. Angels get Board control/veto power2. Unrealistic expectations (ROI, timing, future

valuations, risk)3. Lose interest, change priorities – but still want to

“protect investment”4. They are anti-VC5. Many, small investors6. Want to create complex capital structures7. At some point prefer capital losses over continued

patience

36

Early Stage Funding Opportunities

Small Venture FundsTypically targeted technology/region focus

Limited capability for downstream investment

Connections to bigger VC?

Validation if right group/Red flag if not

Can pay a big price in dilution/control for small $

Not as many of these as there used to be

37

Early Stage Funding Opportunities

Venture Capital FundsLink to Early StageFor most technology driven ventures, particularly University spin-outs, will need to consider VC funding. It is rarely a question of if, but when.

Start Process EarlyBegin dialogue before you need funding. Build relationships. It is a multi-step process that takes time and thick skin.

38

Early Stage Funding Opportunities

Strategic/Collaborative Partners• Partnerships with larger/funded companies

(Big pharma, public biotech, CROs)

• Unlikely at earliest stages of development – more risk averse than other forms of capital

• Deal terms improve dramatically the further you develop the technology

39

Funding Process and Structures

THE SEARCH FOR EARLY STAGE CAPITAL• Start early, it’s always longer than you think• Pursue alternatives simultaneously, not

sequentially• Utilize your contacts• Added significance gained by due diligence

of potential investors• Beware Investment Brokers

40

Funding Process and Structures

TYPICAL EARLY STATE INVESTMENT VEHICLES (INVESTOR DRIVEN TYPICALLY):

Bridge Loan – A convertible promissory note, typically with a kicker (warrants, conversion discount)•Do not have to value company – converts into first equity financing•Capital structure clean, transaction quicker•But, debt senior to equity

Preferred Stock – A “Series” of Preferred Stock with preferences, privileges over Common Stock (liquidation, anti-dilution, voting)•Must value company (art > science)•Complicates capitalization, typically slower transaction•Can result in future “down round,” complications with investors

41

About Wyrick Robbins• 70 lawyers focused on corporate transactional work for growth-

oriented entrepreneurial companies

• Named No. 1 in North Carolina for Biotechnology Law by Best Lawyers in America

• Recognized as a top firm by Chambers USA in 2009 and 2010

• 22 lawyers selected as North Carolina Super Lawyers for 2010; 17 lawyers included in Best Lawyers in America 2011; 13 lawyers selected to Legal Elite 2010

• 2009 Dow Jones Private Equity Analyst rankings:

• 22nd most active law firm in the nation for venture capital and private equity transactions; ranked 17th nationally for closed venture capital deals

• Top law firm in Carolinas and Southeast for venture capital and private equity transactions

42