Many technology startups fail, often for commercial or business reasons. Some startups, however, fail because their founders don’t properly address certain important legal issues that confront their company from the outset. If you err when confronting legal issues that are critical to your company’s success, it will likely haunt you and your co-founders for the life of the company. One of the biggest mistakes startups make is not involving smart legal counsel early in the life of the business. This is also true of not involving good accountants early on to establish sound financial processes to ensure invested funds are properly used and accounted for.
This blog is the first in a series that identifies some of the most common legal issues that frequently get overlooked by the founders of technology startups, and suggests ways the founders and their counsel can manage the issues and successfully resolve them.
As the founder of a technology startup, your first task is to select the most appropriate type of legal entity to accomplish your company’s business objectives. This decision is important for a number of reasons, including protecting the founders against personal liability, establishing the board of directors and officers to run the company, maximizing the tax advantages of state and federal law, and attracting investors.
Technology startups created in Silicon Valley almost always operate as c-corporations organized under California or Delaware law. Limited liability companies and partnerships are rarely used because they pose tax, valuation, compensation, and management problems for prospective investors.
The corporate form provides a formal management structure organized around a board of directors who set company policy, and executive officers who implement that policy. A corporation provides a predictable and well recognized legal structure that private and public capital markets are familiar with. It also allows for perpetual existence. Venture capitalist are comfortable investing in private corporations, and using those that are successful to access the public capital markets.
Corporations can offer equity compensation to employees, which is a significant component of compensation used to attract talented employees to a new, speculative venture. If the corporation fails, state corporate or federal bankruptcy laws provide for an orderly dissolution that guards against personal liability and protects the rights of creditors.
So long as the corporation follows all corporate formalities and laws, and does not engage in fraud, the corporate form will protect the shareholders, directors and officers against personal liability in the event of a lawsuit. It’s also important to ensure that all business activities are conducted through the corporate form, and not by an individual found or other third party.
It’s important to ensure the articles of incorporation authorize the company to indemnify directors, officers and other specified individuals against personal liability to the maximum extent permitted by state law. It’s also important for the corporation to enter into formal indemnification (and advancement) agreements with those persons it agrees to indemnify to avoid internal management disputes once a lawsuit is filed.
Corporations can be capitalized either exclusively with equity or with a combination of debt and equity. Tax classification as debt or equity has important tax consequences for the corporation and its shareholders. The general distinction between debt and equity for tax purposes is that a debt holder expects the payment of periodic interest and repayment of principal at a fixed maturity date regardless of the issuer’s earnings. By contrast, an equity holder subjects its investment to the risks of the business, and expects to profit handsomely if the issuer does well or lose everything if the issuer fails.
Interest payments on a debt instrument can be paid out of capital, but dividends must be paid out of an issuer’s earnings. Generally speaking corporations prefer to issue debt because they can deduct interest payments made on debt but cannot deduct dividends paid on stock. Thus, the after-tax cost of financing with equity that is expected to pay current dividends – like on preferred stock – is generally higher than financing with debt. Investors prefer to hold equity because of the potential return on investment, and favorable tax treatment of equities upon sale.
The bottom line is that if you dream of starting a technology company your choice of entity will almost certainly be a c-corporation organized under California or Delaware law.
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Finkel Law Group, with offices in San Francisco and Oakland, has more than 25 years of experience providing legal counsel to the founders, directors and officers of technology startups operating in a variety of industries to help them negotiate and properly document all forms of business transactions. When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with a business transaction or investment you may be contemplating for your technology company, please contact us at (415) 252-9600, (510) 344-6601, or info@finkellawgroup.com to speak with one of our attorneys about your matter.