How do startup founders manage legal issues and compliance?

BOB MOLLEN , OF COUNSEL , FRIED, FRANK, HARRIS, SHRIVER & JACOBSON

20 Sep 2017

One challenge that US startup founders face is the need to put their business on a good legal and compliance footing at a time when the business is very early stage and poorly funded. Unfortunately, the US is more litigious, and less forgiving, than many other countries, and “foot faults” are more likely to give rise to significant problems.

Founders’ consideration of these issues typically breaks down into the following questions:

1. When do we need a lawyer?
2. When should we incorporate?
3. When should we put in place internal legal agreements, and which agreements are essential?
4. What other compliance steps are necessary?

Do we need a lawyer?

The question of whether founders need a lawyer, and when, is not easy to answer. While there are things that you can do yourself, with the support available online, it can be significantly more expensive, for example, to fix errors in handling initial incorporation, organization and capitalization of a corporation, than to do things the right way in the first place.

There are many places, online and off, to access boilerplate incorporation materials—but these are of extremely variant quality and may or may not be ideal for any given startup’s situation. So, to some extent, the answer here is a question of risk appetite. As founders you take business risk in a number of areas; legal risk is simply another area of risk. However, if you choose to take risk in this area, you should manage it. Quality online materials from leading startup law firms can help. In addition, organizations like Gust Launch provide tools that help you avoid errors that will be difficult, or very expensive, to fix. They may also provide access to lawyers for limited telephonic or online consultation at no or low fees, which may help you decide when you need more focused legal help.

I would like to emphasize one key point about startup use of lawyers. You should only use a lawyer who is experienced in working for startups, and you should insist on fixed or capped fees. Most of what you will need at very early stage can be provided on a cost-effective, standardized basis. Lawyers who primarily work for larger or more established clients, or for local small business clients, on a billable hour basis may not be able to provide services that you can afford, nor will they necessarily be familiar with “market standard” for your needs. See http://bit.ly/StartupProfAdvisors.

When should we incorporate?

Incorporation carries with it certain expenses. Many on- and offline incorporation services, like Gust Launch, reduce or cover some of these expenses, but the costs associated with incorporation will include state filing fees, registered agent fees, and the cost of preparation of relevant legal documents. Additionally, your business will become subject to federal and state corporate income tax return filing obligations, even if it has no income. So when does it make sense to incorporate?

If you are a sole founder working on the development of an idea, and you have no employees, customers or ongoing trials of your product or service, you may be able to defer incorporation.

However, the following factors may give rise to a need to incorporate your business, both to make sure that it owns its key assets, such as intellectual property, and also to provide, to the extent possible, for your limited liability as owner/s of the business:

• You have a co-founder, and need in some basic respects (like reverse vesting of your interests if one of you should leave, see below) to set out the arrangements between you. If you do not incorporate, your business will be treated as a partnership, and the inter-founder arrangements would need in any case to be documented with a partnership agreement. It makes sense to skip that step and incorporate.
• You and others are generating intellectual property, and that IP needs to belong to the business. As discussed below, it makes sense that the IP be assigned to the business from the beginning.
• You are obtaining investment from third parties (either equity or debt).
• The business is retaining employees or contractors. However, while limited liability can be useful in this context, you should note that, even if you incorporate your business, you may not be able to avoid some kinds of personal liability to employees (for example, in New York). You also could have personal liability (notwithstanding incorporation) for (i) failure to pay payroll taxes or mandatory workers’ compensation or unemployment compensation insurance, (ii) misclassification of employees as contractors (see below), or otherwise.
• The business is incurring expenses for which you do not want to be liable personally. However, you may in any case be required to guarantee some corporate liabilities on a personal basis, such as lease expense. You will need to get legal advice on the scope and implications of any personal guarantees.
• The business is interacting with customers or potential customers, or otherwise has a public presence.

This is not intended to be a comprehensive list of factors that drive toward early incorporation, but this hopefully will give you a flavor of relevant considerations.

Given the choice between a corporation and a limited liability company (LLC), I think most founders will find it advisable to use a corporation. The possibility of saving a small amount in taxes with an LLC is usually outweighed by the advantages of C-Corporation status. For more information on this choice, I recommend doing some research, and you can start by reading Gust’s article S-Corps, LLCs, and Tax Savings for Startups.

When should we put in place internal legal agreements, and which agreements are essential?

I’m now getting into an area that is more controversial, since lawyers may disagree as to which early stage documents are essential, and the answer here may depend on the facts. However, I would suggest that, in addition to the documents required to incorporate, organize and capitalize the corporation, the following documents are critical at very early stage:

• Founder arrangements. If there is more than one founder, there should be documentation (which can simply be the share purchase agreement) that provides for “reverse vesting” of the founder’s shares (i.e., that some shares are forfeited) if the founder leaves.

For example, four founders may start off with each of them owning 25% of the corporation. If one of them leaves, she shouldn’t be able to retain all of her interest since: (a) she is no longer contributing to the business that the three remaining founders are building; and (b) she probably will need to be replaced, and her replacement will need a share grant. It is common to provide for vesting over four years, with a one year “cliff” (complete forfeiture) if the founder leaves in the first year. It may also make sense to provide for at least some of the vested shares to be subject to repurchase by the corporation or its designee for fair market value at the time of departure.

You could also have a more detailed founders’ agreement, which can set out these provisions as well as other terms of the founders’ relationships, including voting and approval provisions and the like. However, whether this is seen as essential at very early stage will depend on a number of factors.

• IP agreements. As indicated above, anyone who touches the intellectual property of the business, including founders, employees and contractors, should execute, as early as possible, a confidentiality and intellectual property assignment agreement. This agreement should impose confidentiality obligations in respect of the business’ information, and should currently assign to the business any intellectual property that the person has developed, or may in the future develop (while associated with the corporation), that relates to the business. Note that California has special requirements in respect of these agreements.

Additionally, in many states these agreements may include reasonable restrictive covenants, such as non-compete provisions and the like. However, these restrictive provisions are subject to limitation in some states and, in some (including, in particular, California) do not work at all.

• Employee and contractor documentation. Employees should receive, at a minimum, an offer letter that sets out the key terms of their employment — your employees are entitled to rely on what you tell them about their terms (including in the offer letter). Contractors should have a contractor agreement that sets out the terms of their contractual arrangements. As suggested above, the employee/contractor distinction is important, especially, for employment and tax law purposes. You need to take care not to treat as a contractor someone who would be classified as an employee under federal or state law.

Of course, you will also need stock grant or option agreements if you are providing equity compensation to employees or contractors. In addition, you should obtain legal advice on compliance with federal and state securities laws.

• Investor documentation. If you take friends and family or other third party investment, you will need to document the terms of that investment and also get securities law advice. Convertible debt or simple agreements for future equity (SAFEs) are frequently used at very early stage to minimize legal expense and avoid the need for more detailed investor arrangements. However, the terms of these agreements, which create rights designed to convert in the future into convertible preferred stock, are beyond the scope of this blog.

The discussion above does not address documents needed for your interaction with customers or potential customers (such as terms and conditions or confidentiality agreements), nor does it address, for example, other steps that you may need to take to protect intellectual property, such as the filing of trademark or patent applications.

What other compliance steps are necessary?

A broad discussion of compliance is beyond the scope of this blog. Also, startups’ compliance needs will vary based on the nature of their businesses and where they are located. However, there are three key areas that merit discussion here – tax, employment and insurance.

• Tax. Your startup business (whether or not incorporated) is subject to federal, state and local tax compliance requirements from the time that it is formed. Relevant areas of tax compliance include, for example: (a) federal and state corporate income tax; (b) payroll taxes; (c) real and personal property taxes; (d) sales tax, and the like. You need to be sure that you have obtained applicable taxpayer identification numbers, such as a federal employer identification number (EIN), that you are properly registered at the state and local level, and that you understand what filings and other compliance is required. Startup-friendly tax accountants are typically best placed to provide this advice to startups, since they can address your ongoing tax return filing obligations as well as the initial registrations.
• Employment. In addition to payment and withholding of payroll taxes, you will be subject to other mandatory requirements in respect of employees, including procurement of workers’ compensation and unemployment compensation insurance. Make sure that you understand those obligations. Use of startup-friendly professional employer organizations (PEO’s) can be a cost-effective way for early stage companies to deal with these requirements.
• Insurance. Finally, you should get advice from an insurance broker as to the kinds of business insurance that are appropriate for a startup at your stage. The US is a litigious country, and you will need to consider what insurance you may wish to procure, even at very early stage.

Conclusion

Operating any business, even an early stage startup, carries with it various obligations and risks, including legal and tax risk. There are some risks that you may be prepared to take on board as a matter of business risk, and others that you should not. Educate yourself, and make sure that you obtain appropriate advice.

If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com. See a listing of Bob’s weekly startup blogs on US and international expansion and early stage financing here.

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