Www.smithlaw.com ©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Legal Issues for Start-Ups Merrill M. Mason December 2, 2010

www.smithlaw.com©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.

Legal Issues for Start-Ups

Merrill M. MasonDecember 2, 2010


Steve Jobs, founder of Apple and Pixar: “The thing that drives me and my colleagues both at Apple and Pixar

is that you see something very compelling to you and you don’t quite know how to get it, but you know, sometimes intuitively, it’s within your grasp. And it’s worth years of your life to make it come into

existence.”


“Starting companies are like having babies – fun to conceive but hell to deliver.”

-- Anonymous

…and Then On the Other Hand…


Role of the Corporate Lawyer

Legal Advisor

Business Advisor

Value Adder

Voice of Reason

Introducer

Sounding Board

Confidant


Issues During Start-Up FormationMaking Initial

DecisionsForming Legal

EntityPlanning for the

Future

• Choice of Entity

• Incorporation jurisdiction

• Founder’s Equity Allocation

• Incorporation

• Bylaws

• Board

• IP Assets

• Tax Issues


Choice of Entity • Continuity of existence• Ease of transfer of ownership• Easier to raise capital• Separate entity from owners

C Corporation

Considerations

• Regular corporation meeting IRS test• Difficult choice for startups

S Corporation

• “Incorporated Partnership”• Tax issues in liquidity events• Flexibility in operating agreements

LLC

Limited liability for

stockholders


State of Domicile

• Developed case law• Business-like attitude• Willingness of counsel to provide

opinions• Ease of governance

Delaware Other jurisdictionsv.

• Differences on specific points of law

• Local allegiances• Administration issues


Process of Incorporation• Corporate Name – Need for Distinction• Par Value of Stock – Significance• Initial Officers and Directors• Adopt Bylaws• Payment for Stock

File Charter

Follow up on organizational matters

• Appoint Board• Issue stock• Foreign qualifications• Tax ID number

Charter is a public document


Forming Legal Entity: The Bylaws

• Rules of governance “pulled” from state statutes

What are bylaws?

What do bylaws address?

• Officers, Directors – election, meetings, authority• Organization of Board – special committees• Stockholder meetings

What may be included?

(contract v. charter v. bylaws) • Share transfer restrictions to control shareholder pool• Indemnification to protect Board members


A Critical Asset: The Board of Directors

• Number

• Outside Directors

• Role/Level of Involvement

• Compensation


Going Forward Issues• Identification & Perfection of IP

Rights• Assembling management team –

identify needs – cash and equity compensation

IP Assets

• Allocation and vesting of Founders’ equity

• Dilution v. protection of Founder Interests

Founders’ Equity

• I.R.S. Section 83(b) Elections• Importance of Timing and

Consistency in Valuation of Stock• Avoiding Taxable Income

Taxes


Start-up Legal Mistakes - People

• Improper or non-existent non-compete and invention assignment agreements.

• Employment agreements with out-of-market terms for severance or other items.

• Inappropriate use of titles (too many VP’s who aren’t really VP’s).

• Outrageous nepotism.


Start-up Legal Mistakes - Capitalization• Issuance of stock (as opposed to options) to non-founders.• Establishing unreasonable valuations by selling small amounts

of equity at high prices.• Having dozens of small investors.• Selling preferred stock in small amounts resulting in rights and

preferences that need to be revoked when a venture round comes together (and the preferred is converted to common).

• Not establishing an option pool.• Running afoul of securities laws in issuing stock.


Start-up Legal Mistakes – Corporate Governance• Not establishing a board of directors.• Not having bylaws.• Not taking minutes and recording them.


Start-up Legal Mistakes - Customers

• License agreements with toxic terms (e.g. rights to source code).

• Agreements to provide maintenance or other services without getting paid.


Start-up Legal Mistakes – Technology and Intellectual Property• Using open source code in a proprietary product

requiring it to also become open source.• Poor or non-existent patent writing (and strategy).• Failure to maintain patents.• Failure to file international patents and maintain them.• Poor license agreements for in-licensed technology.• Out licenses with partners which give rights away

without compensation. (Selling the company w/out selling it.)


Start-Up Legal Mistakes - Other

• Privately held company bad habits on the balance sheet (e.g. cars, planes, rental property).

• Related party transactions for real estate or any service.


Buzz Words• S corp• C corp• Option pool• Founders• Vesting• Restricted Stock• Incorporation• Executive Summary

• Business Plan• Intellectual Property• Common Stock• Preferred Stock• 83(b) Election• Dilution• In/Out License• Spin-Out


. . . and Then What . . .

“Only one thing is certain about a new venture: It’s going to turn out very different from its business plan.”

-- William Congolton, Venture Capitalist



Documents

Www.smithlaw.com ©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Legal Issues for Start-Ups Merrill M. Mason December 2, 2010