Legal matters are often the last thing on entrepreneurs’ minds as they struggle to get fledgling businesses off the ground. But new-business owners who don’t take steps to insulate their companies from liability can find their hard work undermined by legal complications down the road.
A host of legal issues require attention in a start-up company’s embryonic years, including establishing ownership structures, ensuring that equity sales comply with securities laws, protecting intellectual property, crafting employment agreements, and other matters that often don’t show up on day-to-day radar screens. The good news is that many law firms have emerging business practices that cater to the unique needs of start-ups, and usually offer flexible fee plans that accommodate their smaller budgets, limited capital, or uncertain revenue streams.
Choosing the Right Entity
One of the first legal decisions start-ups face is what type of entity to form, typically a choice between a C corporation or a limited liability company (LLC). There is no corporate tax with LLCs, meaning the profits and losses of the business “pass through” to the owners’ personal income tax statements, allowing them to avoid double taxation. With C corporations, net business income is subject to corporate income tax, and remaining monies are taxed a second time when they’re distributed as dividends to owners, who must pay personal income tax on them.
How owners intend to fund and manage their businesses should play a big role in choice of entity, says Thomas Martin, a partner with the Dorsey & Whitney law firm in Minneapolis and co-chair of the firm’s emerging companies and venture capital practice. Because venture capitalists tend not to invest in entities with pass-through structures and a limited number of shareholders, forming a C corporation is a better option if multiple rounds of financing may be needed. But if the founders intend to keep the business closely held and foresee little need for outside capital or private equity funding, an LLC can be a good choice, Martin says.
Peter Ekberg, a partner at Faegre & Benson in Minneapolis and co-chair of the law firm’s emerging companies practice, encourages start-ups to form as C corporations if they plan to have more than five to 10 outside investors through multiple rounds of financing. “LLCs do have pass-through benefits, but from a legal perspective they are creatures of contracts, which means you have these long, complicated documents, bills tend to get bigger, and odds increase that people will get confused,” Ekberg says.
A business also can opt to become an S corporation, which is a tax status rather than a business type. S corporations are taxed in the same “pass-through” fashion as LLCs but have certain restrictions, such as limiting the number of shareholders. The primary difference between an S corporation and an LLC is an employment tax paid on earnings. Owners of LLCs are considered self-employed and must pay estimated self-employment tax toward Social Security and Medicare based on their business income. In an S corporation, only salaries paid to employee-owners is subject to employment tax.
Venture capitalists tend to have the same aversion to S corporations as they do to LLCs, but the advantage of the former entity is that it can more easily be converted to a C corporation when the time comes.
Tax issues may take owners of LLCs by surprise, attorneys say, which can result in unwelcome penalties. “They don’t realize they are still self-employed for tax purposes, which requires they pay quarterly federal and state estimated taxes,” says Kimberly Lowe, a shareholder with Minneapolis-based law firm Fredrikson & Byron.
Funding, Ownership, and Valuation
Attorneys also can be important resources for identifying angel investors or venture capitalists, correctly valuing a business, and structuring ownership agreements among multiple founders. Douglas Ramler, a principal with Gray Plant Mooty and co-chair of the law firm’s entrepreneurial services group, says his team introduces start-up clients to potential investors. When possible, they offer flat fees, or may defer fees in return for equity or compensation.
“If a funding deal gets done, we might participate on the back end of it with fee compensation. And if it doesn’t get done, we’ll often provide a discount to emerging business clients,” Ramler says.
First-time business owners are sometimes surprised by the need to comply with federal or state securities laws when raising capital. “A lot of new business owners say to me, ‘I’m not selling securities, I am selling notes and making loans,’” says Jeffrey O’Brien, a partner with Mansfield Tanick & Cohen who oversees the Minneapolis firm’s “INCubation” Center for entrepreneurs and start-ups. “But if you are making general solicitations, the law doesn’t look at what you are selling. It looks at the manner in which you are selling it.”
Securities laws require that you register every sale of debt, and there also are restrictions on paying people who aren’t registered as broker-dealers to help you sell stock in your firm. Not only are those legal violations, they can come back to haunt you if you intend to sell in the future.
“If a company like Medtronic or St. Jude’s is looking at buying a medical device start-up but discovers it hasn’t complied with securities laws, they’ll want the company to go back and fix it,” Lowe says. “If they are considering comparable start-ups to purchase, [they] may even pass it by because of the potential complications.”
It’s also important that businesses with multiple founders create written agreements that detail what happens in the event a founder leaves the company. “Younger entrepreneurs in particular usually feel like everything will work out with their partners, who often are their friends, and there will be no problems throughout the ownership,” Ramler says. “But lives change, new opportunities arise, and there are chances for ownership to walk out the door.” That makes it important to not only detail how the pie is split up, he says, but also to ensure the company receives equity interest back if a founder leaves.
Protecting Intellectual Property
Attorneys also can help entrepreneurs sort out issues regarding all-important intellectual property (IP), including writing complex patent applications and advising on patent types. Protecting IP is important for many reasons, not the least of which is that outside investors may verify defensible and “protectable” intellectual property as a condition of funding.
“The more sophisticated investors will perform due diligence around a company’s intellectual property before they do anything else,” Ekberg says. “They won’t go forward until they know a start-up has its IP ducks in a row.”
Patent protection is a central issue for some emerging businesses. “This is medical products alley, and the purchase price of acquired companies [in that industry] is influenced by the strength of their intellectual property,” Martin says.
Businesses can file a standard patent application or a provisional version. Filing the standard application establishes a filing date and begins a review process by the United States Patent Office that can take up to 36 months to complete. A less expensive provisional application, on the other hand, can establish a filing date but doesn’t trigger the review process. Either filing enables inventors to use the term “patent pending” while further developing or marketing inventions.
“What the provisional application does is get the clock ticking and provides protection for your intellectual property, assuming you pursue the nonprovisional application after one year,” Ramler says. Provisional applicants need to avoid disclosing information about the technology while a patent is pending. Attorneys recommend business owners ask all those with knowledge of inventions to sign non-disclosure agreements.
Legal issues also can arise for entrepreneurs who still have a “day job.” “If someone is on a company’s payroll but also is working on the side as an entrepreneur, there is always the question of who owns the intellectual property for the product or device they’ve developed,” Lowe says. “Is it the company or the entrepreneur?”
Attorneys also stress the importance of having new-business owners sign contracts stating that any intellectual property they develop is owned by the company, not by them as individuals. “An investor with any level of sophistication will insist on seeing that up front,” Ekberg says. “You can’t have founders disagreeing over what portion of IP belongs to one or the other—that is a red flag to investors, and a potential problem for the business. It all must belong to the company.”
Other legal issues that entrepreneurs tend to overlook or need assistance with are trademark, licensing, and Web site naming matters. For instance, start-ups sometimes find themselves grappling with existing businesses over URL addresses.
“New businesses also need to have agreements with those who have invented technology that they want to license, as well as joint venture agreements around new distribution channels they intend to create,” says Brad Lehrman, a partner with Lommen Abdo Cole King & Stagberg, a law firm in Minneapolis.
New businesses hiring employees or independent contractors can run into employment-related legal issues. For instance, don’t misclassify an employee as a contractor, which in an IRS audit can lead to back-owed taxes and penalties. With tax revenues falling and unemployment claims rising during the recession, the IRS and state taxation agencies are more actively going after companies who wrongly classify those doing the work of full-time employees as contractors.
“The employment law experts in my firm tell me it’s an area the IRS is really focused on right now,” Ramler says. Attorneys suggest contacting the IRS to determine the criteria used to make the distinction.
When using contractors or consultants, it’s also essential to have work-for-hire agreements that stipulate that what they create is owned by the business, not the contractor. A technology start-up, for example, would want such an agreement with a contractor writing software code. Under copyright law, whoever creates something automatically owns it—unless a legally enforceable document says otherwise. “That often comes as a shock to entrepreneurs,” Ramler says.
Owners also should stipulate what happens if they are asked to leave the company, Ekberg says. The cushier the severance, the bigger the red flag to outside investors. “I have seen two deals in the past six months that were turned down by outside investors because the company founders had provided themselves 18 to 24 months of severance if they got fired,” Ekberg says. “People don’t want to invest money in those scenarios. They want to see that founders are taking real risk and putting their money where their mouth is.”
Owners should have employees sign any nondisclosure, noncompete, or invention assignment agreements before day one of their jobs. “If employees sign those as condition of employment, there is no problem,” Ramler says. “But if you hire someone, they work for a while, and only then do you ask them to sign the agreement, that is generally not enforceable under the law.” Those restrictions will be valid only if employees receive some form of “additional consideration,” Ramler says, such as additional equity, a cash bonus, or other incentive compensation.
Law firms’ emerging business practices also can provide another valuable service to start-ups: connecting them with a team of other helpful advisors. O’Brien considers referring his clients to trusted accountants, insurance specialists, financial advisors, human resource consultants, bankers, and more as the most fulfilling part of his practice.
“To grow your business, you need a team of skilled advisors,” O’Brien says. “But I always tell new businesses, ‘Do what you do best, and let us do the rest.’”