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Business Law
for the Start-Up Netpreneur

A Seminar On Fundamental Legal Issues

Audience Questions

Q: When setting up a corporation, what's the advantage to declaring no-par value for your stock, or going to par value of a fraction of a percent or one percent?

Mr. Wilson: The states impose something called franchise tax on corporations that helps fund their operations. Different states calculate it different ways. The old trick used to be that they would calculate franchise tax on the number of shares. People started having fewer shares and they started calculating it on par value, so you got penny par because you could do 10 million shares and pay a lower franchise tax. So, people thought, "We'll have no par stock and eliminate the franchise tax altogether." Several states have responded to this, including Delaware. There, you pay more for no-par than you do for penny par. As a result, par value is almost irrelevant in your planning.

Q: For a very small start-up, if you start out as an S corporation, then later your business expands, is there difficulty in upgrading it to a standard corporation which might make it easier to go public? What are the tax consequences of converting from an S to a C corporation?

Mr. Shaw: Basically, the year in which you either revoke your election or otherwise cease to meet all the requirements of an S corporation is bifurcated into two short taxable years. You are treated as an S corporation for the short taxable year beginning January 1 and ending on the day before the event that terminates your S corporation status. As of the day that you revoke or cease to meet the requirements—for example, if you have more than 75 shareholders—on that day you are treated as a C corporation and taxed as a C corporation for that part of the year forward.

Q: Are there any issues we should be aware of in dealing with other people who feel that their copyright rights have been violated when we link to their site—particularly relative to frame technology, where you can have your own site framing somebody else's?

Ms. Gallagher-Duff: There are several issues involving trademarks as well as copyrights. There are several cases in the courts dealing with framing issues as well as linking issues.

Q: When you are starting a company and issuing equity to people who are working for you without getting paid, how do you set the value of the stock when you are issuing options? How do you set the value of the stock when you are negotiating for loans? Do those numbers get made up as you go?

Mr. Wilson: The answer is, with the employees you make it up; with the lenders, you have to prove it.

Ms. Moore: And the IRS cares what number you make up for the employees.

Mr. Wilson: It's worth what the company is worth. I know that's a glib answer, but fundamentally it's correct. You can assign a value you like; an interest in the company is worth a percentage of what the company is worth. In terms of compensation, if you structure it correctly, you will prevent the employee from being taxed on the initial grant, and then the issue becomes one of tax based on appreciation. Up front, if you have a dollar par stock and you issue ten shares, you have a $10 interest, if your investment is only the capital.

Mr. Voltmer: Before the company goes public or before you enter into your first venture capital financing, the value can be set with what you can negotiate with the bank, then with the employees. When you deal with a venture capitalist, you are setting the value based upon the transaction involving that particular third party.

Q: For each stock offering—for employees one, two, three and subsequently—what do you do with the venture capitalists? Are those separate securities offerings? If so, how are they dealt with without getting into trouble?

Mr. Voltmer: With a good lawyer.

Mr. Wilson: Legal careers have been made and lost on the question of whether an offering to one person should be integrated with an offering to another. A great many of your tax dollars are hard at work over at the SEC considering whether the law requires putting such offerings together. The bottom line is, if you are reasonably well isolated in time and purpose—including different types of securities—they probably won't be put together. For those who are somewhat aware of what the issues are, if you start putting a lot of shares out to a lot of different people, you suddenly will have the SEC interested. There are statutory exceptions for a variety of different transactions, including employee offerings, but the short response to your question is that you hope that they are each separate offerings.

Mr. Voltmer: It is a complicated issue and it is one that you ought to keep in mind. Many of our start-up clients have to focus on it. As a lawyer, you try to get involved, as much as you can, in business decisions that a client is making, such as how is the client going to compensate employees, and focus on federal and state exemptions to security registration requirements, the class of securities the client is issuing and the timing for the issuance, as well.

Mr. Wilson: Let me hit on a separate issue involving employee matters because it is an incredibly arcane area. There was a medium-stage company, a typical guy who started in his garage with absolutely nothing. Eventually, his business became an acquisition target and a beautiful one. At the time, he had about five years in and 34 employees. We had a purchase price on the table of about $52 million. This thing looked great. The acquirer, as is quite often the case with reasonably aggressive high-tech companies, wanted to treat the acquisition as a pooling of interest—not recognizing goodwill in the acquisition, but bringing it in as a merger for accounting treatment. That technique was originally designed for mergers but is increasingly being used in the acquisition context. Pooling gets spooked if you have unissued employee options, other promises of issuing shares, or a changing share structure that hasn't either been fully set up, fully vested or completely written and documented in the 18 months before the transaction takes place. Of course, the difficulty is that you always find yourself thinking three weeks ahead, not 18 months. This acquisition fell through. It was 12 months before the guy found an offer for $30 million. For those of you who have that in mind—"Let me get it up and running, jump out. I don't want to ride this thing. I'm in this business for the short term."—be careful about how you set up employee compensation and be sure that you get it finished well before you plan to sell. Don't make promises to employees and then wait until a potential acquirer comes along to complete your option scheme.

Q: Most of these deals that get put together are not among employers and employees, but rather among "partners," for lack of a better term. For example, a guy on the West Coast approached us with a technology. He needed marketing and sales help and some other elements. There is a guy here who I have just gotten to know recently. He and I have to form an agreement as to what we are going to do. There are two other people in Annapolis who are bringing consent to the venture. We have to bring them into it, and these people on the West Coast. How do we set this up? Is this pretty bizarre?

Mr. Voltmer: Actually, it's pretty common. Frighteningly so.

Mr. Jack: Partnership or Shareholder Agreements. What you have are different intellectual property assets, different know-how from different people coming together and consolidating it into a business. Oftentimes, in those types of situations, it will be like a joint venture where you will collectively put together your business plan. Collectively, you will then decide who is going to contribute what assets, what money. That will be spelled out in the business plan and an agreement will wrap on top of that and commit the people.

Mr. Wilson: Yes, what you describe is a partnership or LLC in which three separate entities are shareholders or interest holders. You may have a partnership on the West Coast and maybe the guy here is a sole proprietor. If you are in it together for the long haul, you may be focusing on the entity that's common to each of you, the entity that's going to be held by all three. You may form a partnership at that level and corporations or LLCs at the ownership level up top. The first thing to do is get the shareholders set up. Figure out what each party in that deal is going to do internally, then the three parties which result need to get together and decide.

Mr. Voltmer: It will help if you can align your business deal with the guy on the West Coast. It may not be a straight transfer of that intellectual property into the new venture. If that's not the case, if he is granting certain intellectual property rights, that could dictate the entity. Everybody has to have a heart-to-heart talk with each other. What do you really expect of this? If you can articulate that to the team up here, they could put the right vehicle in place.

Q: What about the opposite situation? If you have a venture in mind, you are one person with some ideas, and you are contemplating bringing other people into it. What comes first, the idea of bringing people in or the entity?

Mr. Wilson: In our experience, almost everyone waits too long. When I say "Follow the money," I mean that you must decide when there are either revenues or multiple partners. If you have the foresight to do it earlier, more power to you. If you set up an entity in advance of getting started, there is great merit in that. You do want to be careful about getting ahead of yourself. If you know precisely what each new entrant is going to bring to the table, then the form of entity to choose can be planned in advance. If you don't know precisely what the partners are going to bring—technology, money, expertise—and if you don't have a clear picture of who brings what and what they are going to get in return, it might be premature.

Mr. Shaw: I would add some minor tax points to that. With the advent of the "Check-The-Box" regulations that make classification a little bit easier for tax purposes, a single member LLC is disregarded for tax purposes. It's treated as if it didn't exist. That cuts down your tax planning considerably and provides some state law protection as a limited liability company without the concurrent tax complexities. Therefore, you haven't limited yourself on the tax side. The other thing to take into account is that, if you are eventually going public and cashing out or selling more than 20% of the business, get into a corporate form. Most likely you want to do that relatively early to preserve the ability to go public in a tax-efficient manner. The bottom line is that you need 80% control of a corporation in order to make a tax-free contribution of property for stock. It's a technical rule for tax purposes, and you want to be very careful about whether or not you can make that. Talk to a tax advisor. If you are going public, you want to think about your tax status beforehand and get into the right entity as soon as possible.

Q: I have heard that there are increasingly sophisticated models for how to value intellectual property. What models have you encountered in various stages of development of a corporation, especially in terms of market viability?

Mr. Wilson: The issue is in the investment banking community. Intellectual property alone has not traditionally been regarded as being worth very much. This, of course, is changing. A lot of environments in which you are working are reasonably new and were not susceptible to the analytic models that existed for manufacturing business. Your general impression that there is development in that market is absolutely correct. I'm not familiar, myself, with any particular models that are gaining acceptance, other than DCF, which most people regard as the best approach. Economic value-added, a DCF variant, is getting a lot of consideration. How do you make the valuations? I'm not familiar with a specific model that is getting more or less attention, and I spend a good deal of my career arguing about how you ought to value intellectual property. The range of approaches is still vast.

Q: There is a lot of talk about whether you should incorporate in Delaware or Virginia. Are there certain states which offer benefits to founders in terms of transferring the assets of the corporation, whether by a sale or IPO? What about being a foreign corporation in Maryland and having to file in two different places?

Mr. Wilson: I don't know if there is any particular difference in the state law about the transfer of assets that would dictate a particular choice. The primary difference in corporation law among the states is the ease of administration and the clarity of existing rules. Each state is slightly different, but the bottom line is that most of the areas that you are concerned about are as follows: What does the board of directors have to do? What are the fiduciary duties imposed on the board? What rights do shareholders have? What kind of change of control provisions are there under state law? Delaware and New York are big, big corporate states. In both cases, there is a lot of case law making these issues much more clear. Most public companies are Delaware incorporated because there is a great deal of relevant jurisprudence. The investment community is quite comfortable with the Delaware statute. Not to say that there aren't some Virginia public companies; there certainly are. It’s an individual decision in each case. You can change your residency of incorporation reasonably easily. There are migration provisions in a lot of states, so if you are in Virginia now, and you are not sure where you are going to go, you don't want to pay Delaware and Virginia. Assuming there is nothing particular in your business plan or capital organization that doesn't work in Virginia, you can incorporate there, and if you need to go to Delaware, you could do that.

Mr. Shaw: You also want to take into account where your investors or members or owners are located—their states of residence—because that may have an impact on state tax issues. For example, one thing I mentioned was that the District of Columbia doesn't recognize S corporations as a flow-through entity. If you have persons who are living outside of the District of Columbia, you might not want to start an S corporation in DC because you may wind up paying entity level taxes which you might not in another jurisdiction.

Mr. Jack: Virtually any corporate lawyer anywhere in America is pretty comfortable with Delaware corporation statutes and can incorporate a Delaware corporation. Not every corporate lawyer in America is familiar with the Nevada corporation statutes. You have greater choice of lawyers if you are in Delaware.

Q: Are there any industry studies which can serve as a guideline to a company that has a range of employees and contractors and is wondering what is "normal" among high-tech companies for providing incentives, such as incentive stock options and stock options in general?

Ms. Moore: There are many such studies. One unfortunate aspect is that they tend to focus on public companies because their market is shareholders who have been presented a proposal to issue another 100 million options to the CEO and want to know whether they are out of the ballpark. There are many compensation consulting firms who are in the business of benchmarking, of telling their clients how their proposed compensation arrangements compare with those of other entities. Such studies probably exist, but, if not, they are certainly something you can commission.

Mr. Wilson: Hunt through Edgar, the SEC Web site. Pick any public company that you know to be a competitor in your area and read the registration statement or anything about employee compensation. It has to be described, at least in general terms. You will get an idea, and, at least, will find out what companies are paying who are looking to pick up your employees.

Ms. Moore: There are also institutional shareholder watchdog organizations in the business of keeping an eye on what public companies are doing. They provide information to shareholders about where stock compensation trends are headed and whether their company is headed in the wrong direction. There is a lot of information about public companies in various places, less on closely-held companies, but it's probably available, if you look for it.

Mr. Voltmer: The June 1, 1998 issue of Forbes has an article on CEO compensations at http://forbes.com/tool/toolbox/ceo.

Q: We have a software consulting company that's an S corporation and has developed some Internet products. We really want to capitalize on those with venture capitalists to develop them, but we don't want to capitalize the consulting firms that we are thinking about spinning-off and creating another corporation. What are the issues we should be considering in moving that intellectual property?

Mr. Shaw: Starting with the tax issues, whenever you are transferring appreciated property outside of a corporation, which presumably this is, you have to be very careful to make sure that you come within a very specific non-recognition provision. Otherwise, a transfer of the appreciated property out of an S corporation will trigger the tax, at least on one level. You also have to make sure that you dot your I’s and cross your T’s for qualifying for a non-recognition transaction, either a reorganization of the company or a proper contribution to a new entity, etc.

Mr. Wilson: If the intellectual property you are talking about will still be used at all in the course of the consulting business at the S corporation level, and if the ownership of that S corporation and the ownership of new company are at all different, you have arm's length issues about the relationship between the two companies. What right does the S corporation have to make use of intellectual property? If you put it in a different place, as long as everybody on both companies is identical in their percentage ownership and each company is identical, the issue doesn't matter too much. That never lasts very long. Uncle Fred and Aunt Mabel each owned 50% and three generations later, all the heirs are suing each other because somebody didn't have the right number of children and it messed up the ownership interests.

Q: When we develop a program for a client, we produce source code that makes the computer do certain things. The client is buying the things that the computer is doing, what it is projecting on to the screens, etc. Where does the source code ownership lie? The client wants a piece of it.

Mr. Voltmer: Depends on your development agreement with the client. The ownership issue is going to be wrestled with in the development agreement.

Mr. Wilson: You'll have an argument about work for hire, if it isn't clearly established, but by and large, I would assume in that case, you are likely on the losing end of that battle

Mr. Berman: I don't know which end you are on. I'm Paul Berman. I'm a partner here at Covington & Burling. We worry about those kinds of issues. For most of the people setting up businesses here, the problem is that when a consulting firm shows up and says—"I'm going to draft and write computer code for you, I'll install the object code on your machine, but I'm going to keep access to the source code."—by and large, in those situations, it's the person who writes the code that starts out being the author, unless (1) there is either an express agreement that transfers ownership or (2) the person writing the code is an employee doing it as part of his or her employment. Your situation is a hybrid of that, but these are the things that in all of your agreements—whether you are a purchaser of code or a commissioner of code—you ought to look at. Make sure that you nail down in your agreements the issue as to the transfer of the software. Everybody is talking about the software as if it were an asset that you can actually transfer. You have to be very careful about this. Take care of those things at the outset, please. We have seen lots of deals foundered because we couldn't figure out who owned what and who had the right of transfer. Take care of them early. It's easy to do early. It's really hard to do later.

Q: It belongs to the originator of that source code up to the point where there is agreement?

Mr. Berman: United States Copyright Code provides that, in the absence of the agreement, the originator of the code is the owner. You need to take care of that with your employees as well.

Mr. Voltmer: I try to get start-up companies to focus on these issues in terms of value issues and the transactional cost involved in resolving them, if they are not addressed properly. If you don't have these issues buttoned down very, very clearly for the person who is going to invest in your company—the investment banker—it will be reflected in the valuation of the company and the price that the investment banker is willing to pay. There is going to be a discount in your company’s valuation because of the uncertainty as to the ownership of intellectual property and the transactional costs in resolving the issue. We have all been involved in situations like this—up at 2:00 in the morning and paying off that one programmer to go away and solve that one outstanding intellectual property issue. It's the wise person who focus on these issues ahead of time and gets them buttoned down. It will save you a lot of time and money in the future.

Mr. Berman: It involves employees, too. The employee is doing the writing in the course of the business. Save yourself aggravation. Get your employees to sign a copyright and patent and invention assignment agreement. Just take care of all that early, and then you won't have an argument with your employee who shows up nine years later and says, "I really wrote that on my own computer on my own time." It has happened.

Q: As a content producer, often larger companies want some period of exclusivity on the content. After that period, exclusivity lapses and they will have nonexclusive use as will you. Who owns the copyright? They will put a seal on it. Can you put it on as well?

Mr. Wilson: Unless you have assigned the copyright, you continue to own it. If you give them a license, even on an exclusive basis, you still own it. They ought to be saying, "copyright you" on their display. You shouldn't be saying, "copyright them." Make sure the copyright notice is absolutely valid, but it's your copyright. They are the only ones who can display it, but it's your copyright unless you explicitly assign it.


Mr. Voltmer: Thank you very much for attending, and please let us know if we can be of further assistance. And thanks to the Netpreneur Program and the Morino Institute for allowing Covington & Burling to put this evening together.

IMPORTANT DISCLAIMER
Covington & Burling is pleased to provide this information as a service to the general public. We hope that you will find the information informative and useful, and we would be delighted to speak with you to answer any questions you may have.
As we are confident you will understand, receipt of this information does not create a lawyer-client relationship. Although we hope that you will find the above material informative, because each legal matter requires individualized attention to its particular circumstances, it is important that you not act on any legal information contained above without first consulting counsel.
We have attempted to provide information that is current and topical. Because the law changes rapidly, however, we cannot guarantee that this information will always be up-to-date, complete, or correct.
To inquire about legal representation, you may contact Ralph C. Voltmer, Jr. at rvoltmer@cov.com or (202) 662-5479. Ralph Voltmer will take you through our conflict of interest and client acceptance procedures and, if your matter clears those procedures, will put you in touch with the lawyer best suited to handle your matter. Once you receive an engagement letter from us, you will be our client. Although we would be happy to hear from you, please recognize that we cannot undertake a representation until, among other things, we are assured that doing so will not involve a conflict of interest. We therefore ask you not to send us any confidential information or information about any legal matter that may involve you without first contacting one of our lawyers and receiving a written statement from us whereby we agree to represent or advise you.



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