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Business Law
for the Start-Up Netpreneur
A Seminar On Fundamental Legal Issues

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Content copyright 1996-2016 Morino Institute. All rights reserved.

Morino Institute

Mr. Wilson: Hello everybody. We are going to cover some pretty dense material tonight in just a few minutes. If anybody out there can come up with a program that reliably compresses what a lawyer will say in an hour into ten minutes, let me know. I'll quit my job and join you.

We'll start by taking a look at the seven basic choices that each start-up faces in deciding what kind of entity, if any, to use as a legal platform for conducting business. Next, we'll talk about the timing of the decision, and, finally, we'll cover some of the decision points that we would use in advising a start-up about which form of entity to use.

Let me begin by outlining your choices. We first have what lawyers and accountants call the sole proprietorship. It actually isn't an entity at all, but if you are not anything else you are a sole proprietorship. Because the sole proprietorship is, for individuals, the "default" form of entity, you need to know what that means in terms of your liability, the extent to which creditors can reach into your house—or anything else.

Second and third, there are the standard state law corporations. These are divided for tax purposes, into two types, S corporations and C corporations. All corporations have limited liability. The shareholders generally are not at risk beyond their investment in the corporation. Although S and C corporations are identical in structure, they have very different tax attributes, of which you'll hear more from my colleague, Bob Shaw.

Fourth and fifth, you can be a member of a partnership, either limited or general. Think of the distinction as a measure of the partner's liabilities for the business and what the other partners are doing. Like the sole proprietorship for individuals, the general partnership is essentially the "default" entity where two or more people are in business together. General partnerships, like sole proprietorships, impose unlimited liability for the obligations of the partnership on each general partner. Let me tell you, general partners are acutely interested in what their partners are up to.

Sixth, there is the limited liability company or LLC. The best way to think of this is as a very flexible corporate form providing limited liability like a corporation but with the tax attributes of a partnership.

Finally, there is an animal called the limited liability partnership. This entity is most commonly used in service organizations and is designed primarily for professional service providers who want to have some measure of protection against the professional negligence of their partners.

That's the playing field. Let's briefly cover the timing for a decision on the form of entity. As a rule of thumb for timing, I use a highly technical legal doctrine entitled "Follow the Money." First, if there are multiple parties involved in your business, it's advisable to decide fairly early how you want to divide the ownership, the investment obligations and the distribution of any profits from the business.

Multiple owners also means that you will need to decide how to steer the ship. As you will see later, the mechanics of how the business is going to be managed, either between owners or among owners and non-owners, is one of the fundamental decision points in choosing a corporate form. When you have more than one person directly involved in the business, it's time to sit down and think carefully about this.

Even if there aren't multiple players, if the business is starting to generate revenues or build assets, it's time to decide on the form of the entity. For netpreneurs, of course, it's important to think about ownership of intellectual property (IP) well before the IP becomes a valuable business asset. If you haven't thought about the ownership and rights to IP well before it’s been created and used in your business, you’ll probably be facing tax or other headaches later in the process. The moral: Think about your corporate form before your IP is established.

OK, assuming it's now time to decide on a corporate form, the question is, "What really matters?" My sense is that six things matter the most in choosing a corporate form.

  1. Who is going to own the business, either now or in the near-term?
  2. What is the nature of each owner's interest going to be?
  3. Who is going to manage the business now and in the reasonably near-term?
  4. How and when is the money going to flow?
  5. What level of personal recourse can you tolerate? How much do you want to shield your personal assets from the liabilities of your business? For example, are you going to be putting your house at risk?
  6. And finally, what happens on tax day?

There are other factors, and the role of each factor in a given choice of entity form will vary considerably from case to case. Unfortunately, for that level of analysis, you have to pay, but we can at least identify why each of these things is important.

First, who owns your business? This relates not only to the number of owners, but also to the nature of their participation. For example, one individual can't be the owner of a partnership because you can't be in partnership by yourself. By the same token, a few individuals can be in a partnership, but not a sole proprietorship. Corporations may have many owners, except that there are limitations on the number of owners for certain kind of corporations: S corporations.

Corporate owners, venture funding groups and, to some extent, public investors may shy away from the partnership form, unless the partnership is a limited partnership with specific tax objectives in mind. It's also important to understand the lifecycle of your investor group. How easily do you want to be able to transfer interests in your business? Should Aunt Mabel be able to transfer her ownership to Bill Gates or to evil Uncle Ned?

Next on the list is the nature of each owner's interests. There are a variety of different forms of ownership interests that you can provide, and these will vary with the entity chosen. You may be able to create different classes of ownership, depending on a particular form, and you'll need to work with your advisors on each of these because each form of entity will be relatively less or more tolerant of different types of ownership interests.

By way of example, you may have preferred or common interests, and some of your shareholders (commonly your employees) may have carried interests at one time or another. The preferred interests (so-called because they have some priority claim to the profits of the business or from the assets of the business on liquidation) may be participating or not, and may have a variety of other special rights, such as voting provisions for particular matters. Trust me, if you get to the venture capital stage, your venture funding source will tell you all about preferred interests, if you don't already know.

The third factor is the management of the business. For example, if you plan to manage the business on your own, the requirement that a corporation have a board of directors might put you off. If there are few owners, partnerships with equal voting power might work, but you may also need to take into account different levels of participation in everyday decision-making. If you will have external professional management, you may find the levels of management authority and ownership begin to diverge in the company. All of these have implications for the entity that you choose.

The fourth factor is the question of money. We always get back to the money. How is it going to flow both to and from the business? What kind of investment are you looking for? What does your business plan say about the timing of revenues and expenses? How fast are things going to happen? These are primarily tax-driven factors, but your business plan is critically important when we are talking about deciding on a form. That means not only "Here is what I have, here is what I'm planning to do," but also, precisely, what does your business plan say about the timing of investments, revenues and expenses—how and when are these going to flow?

The fifth factor is the level of personal liability are you willing to accept. Sole proprietors and general partners, for example, are fully liable for their businesses. On the other hand, subject to some legal mumbo jumbo about piercing corporate veils, corporate shareholders are generally at risk only for what they agree to invest in the company. Your tolerance for assuming liability will therefore be a factor. I should warn you, though, that in the case of a start-up, the notion of limited liability may be a misnomer. For those of you who haven't already been down this road, most venture and bank funding will insist on personal recourse to your individual assets; so, even if you have structured a beautifully bulletproof corporate liability shield, your financial backers will likely insist on personal recourse. This means that they can go after any equity left in the house to the extent that you haven't put the equity up to get where you are. Sorry. That's bad news, but it's true.

Finally, what happens on tax day? This is probably one of the key factors traditionally pointed to in deciding which form of entity to use. The implications of "tax day" are Bob's and Amy's field, and I will let them give you some materials for nightmares on that topic.

The Tax Treatment Of Entities

Mr. Shaw: I'd like to speak about the tax treatment of the various business entities. Bruce has introduced you to at least seven of the ever-growing menagerie of entities under state law through which you can conduct your business. The good news is that federal tax law generally recognizes only three business entities for federal income tax purposes: a corporation, a partnership and an S corporation, which is kind of halfway between the other two.

We'll start with corporations. For tax purposes, corporations are basically state law corporations, plus certain entities that are always treated as corporations, plus other entities that elect to be taxed as a corporation. The classification of an entity for tax purposes has been greatly simplified by what are commonly called the "Check-The-Box" regulations. These essentially let you choose between tax treatment of your entity as a partnership or a corporation, with certain exceptions. The exceptions include a list of entities which must always be corporations for tax purposes and the requirement that partnerships must have at least two partners.

For S corporations, first of all, you must be a corporation for tax purposes, then you must be eligible for, and actually make, an election to be taxed as an S corporation. Some of the eligibility requirements are that there be 75 or fewer shareholders; generally, shareholders have to be individual citizens or residents; and an S corporation can only have one class of stock. That's going to cut down on your flexibility generally.

In the case of partnerships, generally, anything formed domestically under a partnership or limited liability company law is going to qualify as a partnership for tax purposes. As long as you have two members, you will generally be treated as a partnership for tax purposes, unless you elect otherwise.

Now, what's the difference between the tax treatment of these entities? The first major distinction is the number of layers of tax imposed on the profits of the entity. In the case of corporations, you have a double layer of tax. Basically, that means the income of the entity is taxed once at a corporate level. Currently, 35% is the maximum federal rate and there are different state rates. The profits of the corporation are also generally taxable to the shareholders when they are distributed. That's the second layer of tax. When you actually distribute the earnings of the corporation, they are taxable to the shareholder.

In the case of an S corporation, taxable income generally is subject to a single layer of tax. The S corporation is not subject to tax at the entity level. Instead, each shareholder is taxed on their pro rata share of the entity's taxable income, regardless of whether such income is distributed. That increases the shareholder’s basis in their stock, and cash distributions are tax free to the shareholder to the extent of the shareholder’s basis in the stock. This system effectively allows for a single layer of tax.

Partnerships follows the same basic rules I just described for S corporations, except that tax items do not have to be shared pro rata. In fact, there is a great deal of flexibility in how you can go about sharing the tax attributes of partnerships.

Next is the tax treatment of distributions of cash. In the case of corporations, cash distributions generally are taxable as a dividend to the extent of the corporation's earnings and profits; then they are nontaxable to the extent of the shareholder’s basis in the stock; and then they are taxed as capital gain. In the case of S corporations, cash distributions of profits generally are tax free because the shareholder has already paid tax on his or her share of the S corporation’s income and has increased his or her stock basis by the amount of such income. Therefore, cash distributions generally are only taxable to the extent they exceed the shareholder’s tax basis in his or her stock. The same basic rules apply in the case of partnerships. Each partner is taxed on his or her allocated share of the partnership’s income, regardless of whether such income is distributed. The allocation of such income increases the partner’s basis in his or her partnership interest, and distributions of cash are tax-free to the extent they do not exceed such basis.

The next issue is complexity. Corporations are probably the least complex from a tax standpoint. They are very common, have been around for a long time, and there is a great deal of well established tax law. It's generally not necessary to reinvent the wheel in the corporate tax area. Therefore, it's a little bit less complex. In the case of S corporations, there are eligibility rules which prevent you from doing very sophisticated things, so, again, they tend not to be too complex. Everything is largely plain vanilla and pro rata. Partnerships, however, can be very complex from a tax perspective because you have the greatest flexibility in how to share distributions or tax attributes among partners. The tax rules are very complicated and are intended to ensure that tax allocations follow the economic arrangement among the partners in order for them to be respected for tax purposes. I can offer you a general warning: if you choose the partnership entity, you may be faced with more sophisticated tax issues than perhaps you care to be.

Now let's talk about flexibility. In the case of corporations, you have a great deal of flexibility for employee incentive plans, choosing different classes of shares and that sort of thing. There are reorganization provisions that generally allow you to change the form of your entity in a tax-free manner. In the case of S corporations, because all of the distributions and allocations have to be pro rata, you don't have much flexibility. It's all pretty straightforward. You can't issue a different class of stock or have any type of special sharing arrangement for an S corporation. There is also limited flexibility on employee incentives and reorganizations in the S corporation. Because partnerships are essentially just a contractual relationship, they give you the greatest degree of flexibility in choosing how to structure the economics and tax attributes of your venture. The problem is that partnerships do not use stock, and therefore some of the stock incentive plans that you are going to hear about later on are not applicable in the partnership context. As a result, partnerships have some limitations on flexibility in certain areas, particularly employee compensation.

Now let’s summarize the tax treatment of each of these entities. First, corporations have a double layer tax at both the federal and state level that tends to be a large disincentive from a tax perspective. You have corporate level taxes imposed on the corporation’s income and such income is again taxable at the shareholder level when distributed. Corporations are the least complicated and the easiest to take public. Corporations allow for very flexible employee incentive plans and provide flexibility on classes of shares, flexibility that generally isn’t available in the partnership or S corporation area. Another tax issue raised by corporations is that once you contribute appreciated property to a corporation, it's very difficult to get it back out again and in the hands of an individual or a different taxpayer without triggering two levels of tax.

In the case of S corporations, you have a single level of federal income tax—except in some limited cases where you start out as a regular corporation and only later switch over to S corporation status. States differ on whether they apply a single level of tax to S corporations. For example, Washington, DC does not treat S corporations differently from other corporations. The S corporation’s income is taxable to its shareholders regardless of whether it is distributed. Cash distributions generally are only taxable to the extent that they exceed stock basis. The eligibility rules for S corporations may or may not work to your advantage. These rules tend to keep the company small and simple, but that may not be what you want to have happen. There is limited flexibility in the area of S corporations, because you have to retain your S corporation status. Just like a corporation, once property is put into a corporation, it's difficult to get it back out without triggering tax. At least in this case it would only be subject to a single level of tax.

In the case of partnerships, you have a single layer of federal and state income tax, just about the largest tax incentive you can get. Partnership income is taxed to the partners regardless of whether it is distributed. Cash distributions are only taxable if they exceed the partner’s tax basis in his or her partnership interest. Partnerships are the most complex entity for tax purposes. If you look at a partnership agreement, it's going to contain an awful lot of tax boilerplate language—pages and pages of tax provisions that you are not going to understand, at least not without a lot of effort. Partnerships provide the greatest flexibility in deciding who is to get cash and at what time and how you are going to share particular items of income, gain or loss. In contrast, partnerships generally have limited flexibility in certain areas such as employee incentives. Unlike the corporate areas, you do not trigger a tax when you have property going into or out of a partnership.

Corporate Governance: Techniques For Predictable Sharing Of Control

Mr. Jack: I'm going to speak about governance and control issues in corporations, although many of these issues are also applicable to the other entities that Bob and Bruce were discussing. In corporate governance, there is a tension between two basic principles of decision-making: the democratic principle of majority rule; and the golden rule, which is "he who has the gold, rules." In a developing company, which of these two principles should carry the day depends upon the situation the company may be in, so let me address four different situations.

  • First is the start-up company. The issue here is preparing the "prenup," or agreement for the co-founders.
  • Second are companies with a founding entrepreneur plus employees who are also shareholders. The objective here is to give employees an equity stake in the business while avoiding mutiny from the employees.
  • Third is outside financing, when the founders may have to give up some management voice to the venture capitalists.
  • Finally, but not to be overlooked early, is estate planning. The goal here, for any family-owned company, is to shift equity, but not control, to the next generation.

In each of these situations, management may want to use some combination of the following five mechanisms for establishing predictable governance.

The first mechanism is a shareholder agreement. This is the basic tool that may be used in any of the four situations that I mentioned. Shareholder agreements are contracts among shareholders that address multiple control issues, including voting rights, share transfer restrictions, ground rules for major company decisions and methods for resolving deadlocks. I'll discuss each of these issues in a moment.

The second mechanism for establishing predictable governance is a voting trust. These are a little less common and less adaptable than shareholder agreements since they only address voting rights. A voting trust is a trust that holds shares and either gives trustees the discretion of how to vote or directs trustees to vote in a certain way. Voting trusts are often used to permit parents to transfer equity, but not control, to children. They are also used by a control group to pool votes for an election of an agreed slate of directors. Some states limit them to ten years.

The third, and least-used mechanism for establishing predictable corporate governance, is the irrevocable proxy. Proxies grant someone else the right to vote your shares. Generally, a proxy is revocable but it could be irrevocable when "coupled with an interest." Because the law on irrevocable proxies varies from state to state, it should not be relied upon as the sole control-sharing mechanism.

Fourth are Articles of Incorporation provisions. The Articles of Incorporation is the basic document that establishes a corporation. In it, one can establish different classes of shares with different voting or economic rights, majority voting requirements for certain actions or establishment of preemptive rights that I will discuss in a minute. One caution to remember about Articles of Incorporation is that it is a public document filed with state corporation commission.

The final control-sharing mechanism on my list are bylaw provisions. Bylaws set out the parliamentary rules for corporate action, so they can be used to establish supermajority voting requirements or special quorum requirements, such as the required presence of founders if certain votes will be taken.

Now that you know the basic tools for predictable control sharing, what issues should these tools address? The first and foremost issue is the election of directors. Since the business of any corporation is managed by its board of directors, control-sharing mechanisms should address board size and board composition. That is, who should be on the board?

The next major set of control rules are ground rules for major company decisions. Examples of these include procedures and voting requirements for sale by the company of substantially all of its assets or a merger, and procedures and voting requirements for amendments of the Articles of Incorporation or bylaws.

Another key control concern is the ability of the company to issue additional shares. Because shares represent both economic and voting rights, issuance of new shares may dilute the founding shareholders' stake in the company. Two ways to address this concern are preemptive rights and other antidilution provisions. Preemptive rights give shareholders the opportunity to preserve their stake by buying shares at the same price being offered to third parties. Because it costs each shareholder money to preserve his or her position, it might not be ideal under all circumstances. Simpler antidilution devices include consent requirements in shareholder agreements and limits in Articles of Incorporation on the number of authorized shares.

Another set of control issues involves share transfer restrictions. The three major decisions here are whether to impose:

  • Company Call Rights, for example, the company's right to repurchase shares from an employee shareholder when the employee leaves the company,
  • Company Right-of-First-Refusal, or
  • Shareholder Right-of-First-Refusal.

Company Right-of-First-Refusal and shareholder Right-of-First-Refusal provide that when a shareholder wants to sell his or her shares in the company, and has a willing purchaser, the Right-of-First-Refusal gives the company or the other non-selling shareholders the right to buy the shares by matching the prospective purchaser's offer.

Related to share transfer restrictions are sale participation rights; that is, tag-along and drag-along rights. Tag-along rights are important to minority shareholders because they permit a small shareholder to tag-along on the sale of a controlling interest in the company—that is, to sell his or her shares in the company on the same terms as the majority shareholder sells his or her shares. Conversely, when the majority shareholder wants to sell, drag-along rights give the shareholder the right to drag along the minority shareholders and require them to sell their shares in the company on the same terms that the majority shareholder sells his or her shares.

The final control issue that might be addressed is resolution of deadlocks. When a board and shareholder group reaches an impasse, the default resolution in the corporate law is to dissolve the corporation. That may not be desirable, so the founders instead may wish to provide (in a shareholder agreement or otherwise) for an alternate deadlock resolution mechanism. These may include arbitration of disputes, or in unusual cases, the appointment of a "super" director to break the tie.

*IMPORTANT DISCLAIMER*
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