Startup Checklist: 10 Legal Issues Founders Need to Know

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Startup founders make countless decisions about their businesses. Here’s a list of 10 legal issues that can make-or-break their businesses:

1. Choice of Entity. Although many factors go into determining whether to form a startup as a corporation or an LLC, two important factors are the startup’s funding and hiring plans. A startup will typically form as a corporation if founders expect to raise venture capital (generally $1 million or more), as VC firms often prefer to invest in a corporation to avoid the pass-through profits and losses of the LLC being attributable to the individual partners of the VC firm. Further, if founders intend to incentivize employees through the issuance of stock options, a startup will typically form as a corporation, as a stock option plan of a corporation is typically less expensive to put in place and easier to administer than a profits interest plan of an LLC.

2. Jurisdiction of Formation. Although forming a startup where its headquarters is located is generally fine, the most popular jurisdiction in which to form a startup is Delaware, primarily because

• Investors are most comfortable with investing in Delaware entities.
• Delaware has flexible business statutes.
• There is extensive business law precedent in Delaware.

Founders should also consider the costs associated with engaging a registered agent in a state of formation where the startup is not located and qualifying to do business in other states.

3. Vesting of Equity. Founders should consider whether their equity should be subject to forfeiture over time (commonly referred to as “vesting”). For instance, if one founder leaves the business, the other founders may not want that founder to keep his or her full equity. In connection with receiving shares subject to vesting, however, the founders must be sure to make a timely election (within 30 days of issuance) under Section 83(b) of the Internal Revenue Code to avoid adverse tax consequences when such equity vests.

4. Stockholders’/Operating Agreement. With multiple founders, a vital document to put in place in connection with the formation of the entity is a stockholders’ agreement (for a corporation) or an operating agreement (for an LLC). Such agreement will typically address the management of the entity, the right of founders to participate in future equity issuances, and the rights and obligations of founders with respect to equity transfers.

5. Restrictive Covenants. Founders and investors in a startup certainly do not want to see a founder leave and form a competitor or solicit clients or employees away from the startup. Therefore, whether it’s in the stockholders’/operating Agreement described above or in a separate agreement, each founder should be bound by reasonable restrictive covenants.

6. Assignment of Inventions. Founders, employees, developers, suppliers, and other contractors should all be bound by a written agreement stating that all intellectual property created in connection with the services performed for the startup is assigned to the startup. Absent a written agreement, the individual or entity providing the services will generally have ownership rights in such intellectual property, which will cause problems for the startup when it is looking to raise capital or be acquired.

7. Patent Protection. Filing a patent application early in the development of a technology is often very important, because the U.S. operates on a first-to-file basis — meaning that the first person to file a patent application has rights for protection of the invention. Plus, a patent application must be filed within one year after the first public disclosure in order for technology to be eligible for protection.

8. Equity Incentive Plan. In order to incentivize key employees and consultants to help grow a startup, the startup may grant such individuals stock options (in a corporation) or profits interest (in an LLC). These grants need to comply with IRS rules in order to be tax advantageous to the startup and the grantee, but are a very effective way for the startup to incentivize employees without having to expend cash.

9. Debt or Equity Financing. Founders often consider whether to raise funds through a debt or equity financing. Many factors go into determining what type of financing is most appropriate and likely to succeed. However, if founders would like to raise seed capital without having to value the startup, they can raise capital pursuant to a debt financing (convertible notes) which provides that the debt will convert to equity at a discount to the price offered in the next equity raise.

10.  Recordkeeping. Founders should stay well organized from the start, and keep all important or executed documents of the startup in one place. Investors and acquirors will need to review all such documents in connection with a transaction, and therefore the startup will save time and money if such documents are organized.

Terrence M. Kerwin is an attorney with Fox Rothschild LLP.

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