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What are the first legal issues I should consider when founding a company?
What are key documents and agreements that a new company needs to have?
A bootstrapped company needs to file the necessary formation documentation, set up its internal governance mechanisms, issue its equity and make sure it owns all of the relevant intellectual property underlying the new venture. Every company needs to file either a Certificate of Formation (for a Delaware LLC) or Certificate of Incorporation (for a Delaware
C-Corporation) with the state of Delaware. Companies also need to memorialize their rules of internal governance – for a C-Corporation that would be found in the company’s Bylaws and in an LLC that would be in the LLC Operating Agreement. C-Corporations also need to make sure to properly appoint a Board of Directors to run the company, and see to it that the Sole Incorporator resigns. Everything after that is dictated by the context of the specific company. The company will want to issue equity out to its founders and likely subject those founders to four-year vesting if there are more than one (and don’t forget your 83(b) filing!!). Most companies will want to establish an employee Equity Incentive Plan and allocate a portion of the authorized equity to that plan. You also want to make sure that the company, and not the founders or employees, own all of the necessary intellectual property by having each founder and employee sign a Proprietary Information and Invention Assignment or Technology Assignment Agreement, as applicable. If you are operating in a different state or states than where your entity is incorporated (for example, a Delaware corporation with its base of operations in New York), you will want to file Foreign Qualifications to do business in any applicable states. Finally, as always, the company will need the proper board and stockholder (or member) resolutions approving, as necessary, all of the foregoing actions, documents and equity issuances.
How should entrepreneurs leverage their Bowery Legal advisors?
We want our clients to remember that even though we specialize in providing legal services, we also have the added benefit of having worked for years in and for private companies in all stages of the company lifecycle. This gives us tremendous insight into the often intertwined commercial and legal issues our clients regularly face. Clients that rely on us strictly for legal advice are only tapping into part of what makes our expertise so valuable. This might be your first time founding a company, but we’ve been down this road several times before, which gives us the ability to anticipate not only what is around the next corner, but the corner after that as well. Our clients should think of Bowery Legal as strategy consultants with an expertise in law.
Why should I form a business entity?
While it is possible to conduct business without establishing any sort of formal corporate entity, there are a variety of reasons why it is a good idea to set up your business as a corporation or an LLC.
First and foremost, establishing a formal business entity provides founders with the benefits and protections of limited liability. This generally means that the liability of a business owner to satisfy legal claims is limited to the amount that owner has invested in the company (along with the value of the company’s assets). Without the benefit of limited liability, creditors, customers, partners and other parties that do business with your company can go after the personal assets of business owners in a lawsuit if the business does not have adequate funds to pay off a legal claim. On top of that, in a partnership without limited liability, all partners are jointly and severally liable for the acts of the other partners. This means that if one partner acts negligently, recklessly or fraudulently, all partners could be liable to satisfy the full extent of any claim. On the other hand, with limited liability, partners and co-founders that did not participate in any of these acts would be personally protected.
There are also other benefits of forming a business entity. One is the potential to save money on taxes, which is a major benefit for early stage founders that are often struggling to make ends meet. Another is related to ownership of intellectual property. Most founders assign all company related intellectual property to their business entity right after the entity is legally formed, to make sure that all IP that is of value to the enterprise is owned by the entity itself and not owned jointly by the various founders. Joint ownership of IP can be extremely complicated and create a variety of economic, legal and logistical issues for a business as it grows and tries to bring investors on board. So, absent extraordinary circumstances, it’s better for one entity to retain ownership of all company IP even if the product was a collaborative effort. That way, all owners of the business are growing value in the business itself. Finally, if you hope to bring in outside investors, it is highly unlikely that they will invest in your business idea unless that investment flows through a company, with all of its attendant structural and legal protections.
What type of legal entity should I choose for my business?
When you are starting your business, one of the most important issues you’ll need to address is how to structure your legal entity. As with many legal questions, there is no one-size-fits-all answer here, we need to look at the context of your specific business and choose the entity type that will work best for you. As a general matter, all founders should look to establish a formal legal entity to get the protection afforded by limited liability, amongst a variety of other potential benefits. For most of our clients that would mean setting up as either a Limited Liability Company (commonly referred to as an LLC) or a Corporation.
If you plan on raising money from investors, in particular companies that intend on raising venture capital, a C-corporation (or C-corp for short) is the preferred entity structure. There are a variety of reasons for this. C-corps have stock, which the company will issue to its shareholders (which of course will include its investors), and that stock is much more easily transferable for investors than interests in an LLC. C-corps also have a well-understood and standardized structure for the distribution of incentive equity, typically in the form of options to purchase stock, which can be used to attract, incentivize and retain key talent. Also, many investors, especially VC investors, are focused on a company exit in order to cash in on their investment, either through an IPO which is impossible to do as an LLC, or by the company getting acquired, which can also be much more complicated when dealing with an LLC.
If you are starting a business that you believe will be smaller in terms of number of employees and grow in a more organic fashion, maybe with a couple initial investments to get off the ground, but not the type of high-growth, repetitive investment cycle that is common in the world of venture capital, then an LLC or S-corporation might be right for you. The major benefit of using these entity types is the tax savings – LLCs and S-corps can be taxed as “disregarded entities” which means that the only tax hit the company and its owners will be on the personal tax returns of the company owners. Owners of LLC also have the benefit of passing through company losses as a way to offset their individual tax returns. C-corps on the other hand cannot pass losses through to its owners and have to deal with double-taxation, meaning business income gets taxed once at the corporate level, and then shareholders get taxed again on their personal tax returns if they receive dividends from the business. The thing to keep in mind with LLCs, however, is that even though the initial setup and structure may seem simpler than that of a C-corporation, the administration of an LLC and in particular the tax issues for both the company and its members and employees can end up being a lot more complex, time consuming and cost intensive than you might think. On top of that, it’s not always easy, and can be expensive, to convert an LLC to a C-corp if you decide down the line that you made the wrong entity choice at the outset.