In answering, I have in mind a startup which anticipates (1) issuing equity to its workforce; (2) seeking third party investment (venture capital and angels); and or (3) going public or being acquired.

It’s all about the (corporate) constituencies, their expectations, their needs, and the ease of meeting those expectations.

1.  Work Force.

A.  Employees and consultants.  Most employees and consultants have are familiar with stock options or restricted stock units (for those that have worked with some public companies or very successful pre public companies).  These can only be issued by a C corporation or an S corporation.  Most are not familiar with options to purchase LLC interests (or whatever name someone might be giving to them).  So, by having an LLC, you have already created a marketing obstacle to this constituency by needing to explain why you are deviating from the norm.  Oh, and when you are explaining, you’ll need to explain tax consequences of option exercise of a pass through entity which is an entity where taxation does not occur at the entity level but rather is passed through to the owners.  In English, this means that if they exercise but do not sell (which happens with departing employees before a company is public), then the company will need to issue them an IRS K-1 report every year to report on their taxes and, if the company is profitable, they will have to pay their share of the tax, even if the company does keeps profits to finance growth and does not distribute it to owners.  The result is the same for an S corporation which is also a pass through entity.  Also, S corporations can only have 100 shareholders which is not going to work.

B.   Founders.  Founder’s stock?  Yes please.  That can be issued only by a C corporation or an S corporation.  Founder’s LLC interests?  What are those?  You may have the same marketing issue for the curious founder.  You do not want to be explaining this to your co founders or worse, if you find yourself needing to recruit a new founder six months after formation.

2. Investors

A.  Venture Capitalists.  Most venture capitalists will not invest in a pass through entity like an LLC or an S Corporation.  It is that simple.  The reason is because the VCs themselves  are usually structured as pass through entities (LLCs or Limited Partnerships).  They do not want to deal with the hassles of annually passing through the K-1s of each of portfolio companies to their investors.  And, their investors want it less.  In some cases, they have foreign investors which makes it a much bigger headache, if not outright impossible.  Note also that with an S corp, a corporation can only have one class of stock outstanding, so this wreaks havoc on the way VCs invest (with securities with various rights, preferences and privileges over sweat equity owners and parties who invest at different times).

B.  Angels.  Domestic angels are probably more willing individually to do invest in a pass through, but they will have the concerns about the other constituencies and, if given a choice, would probably prefer a C corporation.

3.  Exit

A. Merger.  Take a look at your prospective acquirors.  Most of them are corporations.  It is easier to complete a corporation to corporation merger than an interspecies merger.  More important, if the currency of the transaction is stock, you can probably get tax free treatment in a stock for stock exchange but will not be able to get it in a stock for LLC interest exchange.

B.  IPO.  Take a look at the public companies in your space.  They are all C corporations.  If you are fortunate enough to get to that point, the last thing you want to do is spend time with investment bankers trying to convince them why your company should be the only public LLC in the space.

That should be enough.  But there are other legal and accounting issues involved.  A C corporation is the easiest to form.  Accounting for capital account balances and preparing Schedule K-1s annually is expensive and time consuming.  The “double tax” rarely occurs in the early days because profits get retained for business growth.  Tax losses allocated from pass throughs will usually turn out less than expected.

Michael W. Prozan, Attorney at Law  +1 650 348-1500  mike [at] mgcgroup [dot] com This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.

What Do I Look For in Choosing a Start Up Lawyer?

by Mike Prozan on January 16, 2013

What should I look for in choosing a start up lawyer?

  • Experience. Experience in working with pre public technology companies.  Experience is the one absolute.  A lawyer without adequate experience can do more damage to your company than no lawyer at all.
  • Good personal fit. You will be receiving a lot of advice from your attorney.  At an absolute minimum, you should respect the individual.  Preferably, you should like your attorney and think you will enjoy working with that individual.
  • Accessibility. Is the lawyer going to be accessible to you?  You may really like a big, expensive lawyer from a brand name firm, but how accessible is that lawyer to you really?  Or are you going to be pushed down the chain to someone with substantially less experience most of the time?
  • Price. You should be able to work out something that is comfortable to you.  In my experience, more expensive lawyers are not necessarily better lawyers than lawyers that charge more modest or mid range fees.  However, I find that lawyers who work to cheaply are often worse lawyers.

What is less important?

  • Size of firm.  At this stage of your development, whether you are with a large, expensive, brand name firm, a small firm, or a solo practitioner really does not matter.  Some think that an investor makes an investment decision based on the law firm.  Wrong.  An investor makes a decision on the problem being solved, the size of your market, the quality of your solution, and your management team, not your law firm.

Michael W. Prozan, Attorney at Law  +1 650 348-1500  mike [at] mgcgroup [dot] com This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.

When Do I Need a Lawyer for My Start Up?

by Mike Prozan on April 27, 2012

When do I need a lawyer for my start up?

While your start up may need a lawyer sooner, typically, I find that start ups first need attorneys at one of three times.

First, when more than one person anticipates equity in the company. A lawyer helps to ensure that the parties: (a) document what each party is to receive; (b) address vesting issues; (c) make proper tax filings; and (d) ensure other important terms and conditions are in place to ensure that the departure of one does not impede the success of the Company.

Failure to address these issues properly can cause Company killing disputes over equity allocation later; permit one founder to walk away with equity far in excess of the contribution; create unintended adverse tax consequences; or otherwise impede the success of the company.

Second, when more than one person is involved in the start up and intellectual property is being created. Failure to properly put the intellectual property into a corporation so that the collective efforts are owned by a single entity can create havoc if one person leaves. Say two people are working on code and one of them leaves. If the code is owned by the corporation, then the departing party should have whatever pre-determined equity rights exist upon departure. But, if two people are working on the code not properly place in a corporation and one of them leaves, the departing person can lay claim to part of the code and impede use of it by the company or remaining founder.

Third, addressing issues with employers or while performing contracting services for others (or having had an agreement in place with a prior employer or party for whom you provided services to on a contract basis), you would do well to consult a lawyer to minimize any claims that working on your start up by those third parties.

What happens if I don’t see a lawyer early?

Maybe nothing.  Maybe it will bring an end to your company.

Problems that can be addressed easily early become much more difficult and costly to fix later, particularly if the parties wait until a dispute arises. They can mean the difference between the success and failure of your company.

In one case I litigated, the parties failed to get the proper documentation in place over a number of years. Right now, one person is claiming up to 100% equity in the company and claims that the company does not own intellectual property. He filed a total of five lawsuits in three jurisdictions against five individuals and the company itself. Because they are being sued personally, the individuals cannot walk away.

While that kind of lawsuit is uncommon, it is not at all uncommon for disputes which could have been avoided through early use of an attorney to end a company or require a lawsuit to resolve.

Michael W. Prozan, Attorney at Law  +1 650 348-1500  mike [at] mgcgroup [dot] com This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.