Do It Right The First Time, Part II: Visit the Doctor or House Call?

Antone Johnson , Founding Principal , Bottom Line Law Group

8 Dec 2011

In Part I, I gave a quick summary of the who, when and why of forming and documenting a new startup company. This week we’ll delve into what, exactly, is necessary or desirable to lay a solid legal foundation for a startup to build upon.

I’m reluctant to give legalistic disclaimers, but in this instance, I do need to emphasize that the material in this article is legal information, not legal advice. Unless you’ve engaged my firm to represent you or your startup, we do not have an attorney-client relationship. I urge all entrepreneurs to consult and develop a good working relationship with a qualified startup lawyer.

Continuing my medical analogy from Part I, the documents are like powerful prescription medications and your lawyer plays the role of the physician. This holds true on many levels; for example, patients like to understand the basics of prescription drugs they take, including risks and benefits, likely side effects, alternatives, and so forth. Likewise, founders can benefit from understanding basic characteristics of the overall legal structure, formation and governance documents, rights and responsibilities of team members, etc. Readers can anticipate my next point in continuing the analogy: It makes no more sense for a non-lawyer to prepare fundamental legal, governance, equity and intellectual property documents than it would for a patient to self-diagnose and begin taking prescription-strength antibiotics or other medications.

Stepping off the soapbox, let’s examine the highest level “To Do” list for a new startup:

Formation, Governance, and Equity

• Pick a name for the new legal entity (e.g., “Newco, Inc.”) and search for its availability as a corporate name, domain name, and trademark (all separate inquiries)
• Determine the allocation of equity among co-founders, early employees or other service providers, and future contributors as applicable, as well as the vesting schedule, if any, that will apply
• Determine who will serve on the Board of Directors and in executive officer positions (usually founders)
• . Legal Structuring – Howard Morgan” href=”http://videos.gust.com/video/Legal-structuring;search%3Atag%3A%22structuring-your-business%22″>Form a legal entity to operate the business (we’ll use a Delaware corporation as an example for Newco)
• Appoint Newco’s initial Board of Directors
• Adopt Bylaws and any other necessary documents to formalize the governance of Newco
• Take Board action to authorize everything done by the founders to date, appoint executive officers, authorize issuance of stock, approve forms of common agreements, authorize the opening of bank and brokerage accounts in the name of Newco, delegate authority to the appropriate people to manage those accounts, set the company’s fiscal year and place of business, and so forth.
• Take any steps needed to qualify Newco to conduct the business it plans to conduct wherever it’s located (for example, a filing made in California qualifying a Delaware corporation to do business there if the management team is located in San Francisco)
• Enter into agreements between Newco and founders, early contributors, outside advisors or service providers under which they contribute or assign all intellectual property related to the company’s business to Newco in exchange for the issuance of founders’ stock (Common Stock)
• Make escrow arrangements for restricted stock (i.e., founders’ shares subject to vesting) and IRS filings for most favorable tax treatment of those shares
• Consummate the stock issuances, make any necessary securities filings and issue the corresponding stock certificates.

When people ask me what it takes to “incorporate,” often citing very low prices quoted by filing services, the first thing I like to point out is that they’re referring to #4 alone. A more complete description of the whole list might be “formation, governance, asset contribution and initial stock issuance.” Yes, it’s a mouthful. None of it is optional for a classic tech startup – that is, a small enterprise that aspires to create value through innovation and rapid growth, with a goal of being worth tens or hundreds of millions of dollars someday. The risk is simply too great. Many corporate lawyers make a good living cleaning up messes created at inception by do-it-yourselfers or other lawyers working outside their areas of expertise.

Almost nothing on this corporate list is work I would recommend to do-it-yourselfers. From choosing a legal entity or jurisdiction to properly documenting IP assignments and stock issuances to complying with securities laws and avoiding potentially enormous tax penalties in the future, there is plenty here to warrant consulting a professional. For those of us who do it every day or every week, there is also a “well-worn path” involving reams of very familiar-looking documents that will take relatively little time (and therefore cost relatively little in legal fees) to prepare for a new startup. Perhaps more importantly, investors and their counsel take comfort in seeing very standard-looking, “vanilla” startup corporate documents similar to those they’ve seen for many years in other deals with other companies.

For those who feel compelled to at least give it the old college try, the first five steps or so are most conducive to DIY. A crude rule of thumb is that anything involving the issuance of stock or options, or promises, agreement, commitments or arrangements to issue stock or options in the future, has complications that merit involving legal counsel and/or tax advisors.

The next category is more promising for those who aspire to the corporate legal equivalent of the Homebrew Computer Club:

Common Operating Documents

• Offer letters for employees
• Independent contractor or consulting agreements
• Advisory board agreements
• Small-dollar-amount, routine commercial agreements
• Confidentiality or non-disclosure agreements (NDAs)
• Employment handbooks and policies
• Website terms of use and privacy policies
• Office and equipment leases
• Strategic partnership or distribution agreements
• Sales contracts accounting for significant revenue

No doubt there are many others, but these are common, illustrative examples. Taking them in groups, 1-5 are driven primarily by commercial terms determined by the business people; once in possession of a well-drafted template, I’ve found clients are often happy to prepare these on their own in most situations, involving lawyers only in unusual or more complex arrangements. There are still traps for the unwary in some of these, which your lawyer can highlight. Employment law is trickier (#6), in part because it changes by state as well as over time, but it’s possible to rely on a relatively new “state of the art” employee handbook for the state in which Newco is located that is prepared by a competent law firm or supplied by an organization such as SHRM.

Number 7 is a significant part of my own practice. For startups that are Internet or mobile businesses, as I’ve written before, terms of use and privacy policies are far from boilerplate and are perhaps the most important documents setting the ground rules for the company’s interactions with potentially millions of users. For a bricks-and-mortar business that merely maintains a website but doesn’t do significant business through it, it seems reasonable to use good templates for these documents, at least as a starting point.

Numbers 8 onward are lawyer territory. With a few exceptions such as certain standardized commercial real estate leasing documents, none of these could be described as “boilerplate.” They involve large dollar amounts and/or material business, financial and operational risk on the part of the company. The amounts involved typically justify working with a good business law firm. In the case of revenue contracts, they help pay for the related legal work. For repetitive sales transactions such as insertion orders for online advertising, if an industry standard form isn’t sufficient, it’s often feasible to create a versatile template with the help of a lawyer that the company can use for hundreds or thousands of deals going forward with minimal changes.

Finally, corporate projects beyond the first list above involve significant legal work. Most startups will involve legal counsel whenever doing anything involving the company’s securities, such as adopting a stock option plan, making grants under the plan, issuing convertible notes in a financing round, and so forth. Much of this work poses the formidable risk that “you don’t know what you don’t know.” To throw out a couple examples, if Newco proceeded to adopt a certain kind of employee deferred compensation plan or issue a large number of stock options without being aware of the existence or requirements of IRC Section 409A or Securities Act Rule 701, some very unpleasant consequences could result.

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