Protecting your startup’s intellectual property should be a top priority from the very beginning. This article describes common IP assignment mistakes and issues.
Paying attention to founder stock and seed investments at the outset of can help your business down the line. This article explains the importance of getting these details right at the earliest stage of business.
While venture capital firms are still the most active investors in the startup community, more and more large corporations are investing in early stage startups through separate investment divisions. These corporations have their own existing commercial businesses, but they also seek to make strategic investments in startups in order to capitalize on new technologies in the future.
However, strategic investors pose unique issues for startups that are not present with investments by traditional venture capital firms. When representing a startup considering an investment from a strategic investor, counsel must carefully advise the startup on the potential pitfalls relating to such an investment. This article discusses several distinct issues that counsel should be prepared to navigate when a startup client is considering an investment from a strategic investor.
Why Does a Strategic Investor Pose Unique Issues for a Startup?
When a strategic investor invests in a startup, it often results in an immediate and fundamental conflict of interest. This is because, at the time of the strategic investor’s initial investment in the startup, the startup’s business plans already likely overlap with the strategic investor’s existing business or business plans to some degree. This dynamic is not present when a venture capital firm invests in a startup.
Specific Issues for Counsel Advising Startups Considering Strategic Investor Investment
Board Representation and Confidentiality. As part of its investment in the startup, a strategic investor will typically negotiate to have the right to designate a director on the startup’s board of directors. Special care should be taken to confirm that the director will not inadvertently share confidential or proprietary information about the startup with others within the strategic investor’s management team. There may also be occasions when it is appropriate to exclude the strategic investor’s director from a portion of the board meeting in light of business conflicts between the startup’s business and the strategic investor’s commercial business. Counsel should consider, therefore, whether a separate confidentiality agreement should be entered into between the startup company and both the strategic investor and its director representative in order to address these topics.
Investment Rights. Strategic investors often negotiate for special investment rights as part of any future equity financing round by the startup. The most commonly requested special right is that the strategic investor be provided with a preemptive right to invest in future financings on the same terms presented by any third party. This preemptive right is different from the more common participation right negotiated by venture capital firms, which simply permits the venture capital firm to participate in future equity financing rounds on a pro rata basis in order to maintain the venture capital firm’s existing ownership stake in the company. A preemptive right, on the other hand, allows the strategic investor to subscribe for the entire proposed investment amount, supplanting any third-party investment proposal. Such a right can actually discourage third-party investors from even making a financing proposal to the company in the first instance because a potential investor will be reluctant to spend resources to evaluate the startup as a potential investment if the strategic investor can simply elect to displace the potential investor by investing on the same terms proposed by the third-party investor. Accordingly, any special investment rights granted to the strategic investor need to be carefully considered and negotiated by the startup.
Rights in Future Sale of Startup. A similar issue can arise with respect to a strategic investor’s rights upon a sale of the startup. In particular, strategic investors often negotiate for a right of first refusal in the event of a potential sale of the startup. A right of first refusal provides the strategic investor with the right to acquire the startup on any terms proposed by a third party before the startup may be sold to the third party. But a potential acquiror may be reluctant to evaluate the startup as a potential acquisition target and perform the requisite due diligence if the strategic investor has a right of first refusal and therefore can simply supersede any acquisition offer provided by the third party. Negotiating what special rights, if any, a strategic investor will have in the acquisition context may be the most critical issue facing a startup considering an investment from a strategic investor.
Impact on Commercial Dealings with Third Parties. Another issue to consider is the impact, if any, that the affiliation between the strategic investor and the startup will have on potential customers of the startup in the future. It is not uncommon for the startup’s potential customers to be competitors of the strategic investor. Accordingly, a startup company will want to carefully consider how its potential future customer base may view the strategic investor’s investment in the startup.
Intellectual Property Considerations. Strategic investors often pair their investments in early stage startups with commercial arrangements between the parties. Great care needs to be used in crafting these commercial arrangements to ensure that intellectual property rights are carefully allocated between the parties in a manner that provides the startup with sufficient rights over intellectual property that the startup will need to succeed on its own.
But even absent such a commercial arrangement, if the strategic investor has the right to designate a director on the startup’s board of directors as discussed above, this can create its own intellectual property ownership issues for the startup if the strategic investor’s director subsequently provides valuable business ideas to the startup. A startup therefore may want to consider addressing in advance ownership rights over ideas and contributions provided by the strategic investor’s director representative.
Entering into a financing transaction with a strategic investor poses a unique set of issues for a startup due to the business conflicts inherent in such an investment. However, with careful planning and knowledge of the particular issues involved, counsel can help a startup client successfully navigate through the potential pitfalls of a strategic investor’s investment.
Our MoFo M&A team provide articles and guidance on a variety of topics relating to mergers and acquisitions. See our M&A Publications.
You have finally secured your first paying customer, and your personal credit cards are officially maxed out. You have even passed around the hat and asked employees to forgo salary for a few weeks to help make a major revenue milestone. On the positive side, your startup is experiencing rapid growth, and several angel investors believe in the future of your team. It is time to raise capital to expand your business; however, you are not sure what type of investment will work best for your company. In this article, we will outline several of the different forms of equity you can choose in an angel investment round.
In an equity financing, often called a “priced round,” angel investors directly purchase capital stock from the company. This investment represents a defined percentage or fraction of the company and is based on the current valuation of the company. Generally, angel investors will purchase “preferred” shares of stock, which provide greater rights and privileges compared to “common” shares of stock. For example, if an investor bought 10 shares of a company worth $100, and the company had 100 shares outstanding after the financing, the angel investor would essentially own 10% of the company. Upon a liquidation or sale of the company, the angel investors would generally receive priority (after the company’s creditors) on their preferred shares before the founder’s shares of common stock.
A company might prefer an equity investment because the investment is not considered debt; therefore, the angel investors may not “call” the debt at an inconvenient time years later. However, the disadvantages of an equity investment are many – they require higher legal fees to negotiate, more documents to draft, and a wider range of terms to negotiate. Lastly, they lock in the company’s valuation at a very early stage in the company’s life cycle. If the company raises a Series A financing at a valuation less or about the same as the valuation at the angel investing round, it might trigger damaging legal provisions or signal to outside investors that the company is struggling financially. Typically, founders generally prefer equity rounds to avoid many of these disadvantages.
Convertible Debt Instruments
Convertible debt instruments serve as a useful alternative to equity investments. Convertible debt essentially allows investors to loan money in exchange for the future right to have the debt convert to shares of the company’s stock. The percentage and amount of shares that the debt will convert into is determined by the specific terms of the notes. Generally, the debt will convert to new shares offered in the company’s next equity financing. The convertible note also bears interest at a fixed rate, and the angel investors receive a liquidation priority before all of the company’s stockholders.
Companies often prefer convertible debt to equity financings because convertible debt can essentially delay the question of the company’s valuation until later in the company’s lifecycle. This provides the company more flexibility with later-stage financings. Convertible debt financings also involve fewer negotiation terms and less paperwork; this drives down both legal costs and deal timelines.
The main disadvantage of convertible debt is the nature of the debt itself; investors may call the debt after the maturity date or upon demand at any time. First, an early-stage startup will not have the cash on hand to repay investors if the debt is called. Secondly, companies should carefully evaluate the effect of valuation caps on convertible debt financings. A small cap will allow investors to receive a much higher percentage of the company upon an equity financing, and dilute common investors.
SAFE stands for Simple Agreement for Future Equity. SAFEs provide numerous benefits and are often the recommended investment structure, depending on the company’s specific situation. SAFEs serve as a placeholder for an equity investment in the company’s next equity financing. For startup founders, SAFEs are beneficial because they do not act like debt instrument – they do not accrue interest and do not have a maturity date. Like convertible notes, they do not require the company to adopt a valuation early on.
Generally, SAFEs lack many of the disadvantages of convertible promissory notes and equity financings. However, SAFEs with valuation caps, like convertible promissory notes, can lead to very dramatic gains for investors because there is essentially no upper threshold to what equity value SAFE investors might receive in the next round. For example, if a SAFE has a valuation cap on the next financing of $1,000,000, but the company actually raises a financing at $10,000,000, the investor will likely receive a massive windfall.
Often, the needs of both investors and the startup itself will determine the investment structure. A startup founder should weigh the advantages and disadvantages of the different forms of investments listed above, as well as consulting with experienced professionals. The consequences of choosing the wrong form could lead to serious problems later in the company’s lifecycle.
Over time, parties to a joint venture arrangement may find that their vision or strategic interests have diverged. In these cases, well-crafted exit and termination provisions may help parties retain as much value from the joint venture as possible. This article explains why exit and termination provisions are useful, and explores the primary issues to consider when drafting and negotiating these provisions.
Joint ventures are designed to be flexible business organizations that can dynamically respond to market conditions and other changing circumstances. However, as time passes and circumstances change, parties to a joint venture arrangement may no longer share the same vision or strategic interests; one party may have difficulty performing its responsibilities due to financial or other operational difficulties, or one of the parties may undergo a change of control or default under the joint venture agreement. In these cases, well-crafted exit and termination provisions may be the best way to retain as much value from the joint venture as possible.
There are numerous ways in which joint venture parties “JV parties” can provide for an early exit from, or termination of, a joint venture. An overview of the common themes can provide a good foundation for deal-specific, creative solutions.
This article explains:
- The benefits of contemplating at the outset what should happen if circumstances change significantly for the JV parties.
- Common types of exit and termination provisions, and key considerations for drafting and negotiating those provisions.
For the purposes of this article, a joint venture is an entity created by two or more parties to pursue a specific business in which each party is contributing key assets or capabilities to the pursuit of the joint enterprise. Parties typically use either a limited liability company (LLC) or a corporation as their joint venture entity. The governance flexibility and tax attributes of an LLC make it the more popular choice.
WHY HAVE EXIT AND TERMINATION PROVISIONS?
There are two main reasons why JV parties need exit and termination provisions:
- The default or change of control of one of the parties.
THE DEADLOCK PROBLEM
Many joint ventures have only two or three parties. A typical joint venture structure may have two corporate parents each owning, either directly or indirectly, a substantial equity interest in the corporation or LLC that serves as the joint venture entity. Each party may contribute certain key officers to the joint venture, and these officers will have the authority to make day-to-day operating decisions within the scope of their duties.
Most often, however, a number of significant decisions require each of the parties, through their representatives on the applicable governing board of the entity, to agree in order to implement specified fundamental actions, such as:
- Approval of annual budgets and business plans.
- Raising additional equity capital from the existing parties or others.
- Amendments to the joint venture entity’s governing documents.
- Engaging in a public offering.
- Mergers, acquisitions, and dispositions of all or substantially all of the joint venture’s assets.
- Dissolution or voluntary insolvency filings.
- Incurring debt above a pre-existing limit.
- Granting liens on material assets, subject to predefined exceptions.
- Entering into or modifying agreements with affiliated entities.
- Creating new subsidiaries or making material investments in third parties.
- Granting exclusive licenses under the joint venture’s intellectual property rights.
This list can be expanded and often is.
Even if only a limited number of these actions requiring a supermajority are adopted, disagreements on strategy can materially disrupt the operations of the joint venture. This results in a deadlock in the joint venture management. A deadlock is typically defined as the inability of the JV parties to agree on any one of a particular subset of these supermajority issues.
From a practical perspective, the JV parties normally realize a deadlock is not in either party’s interest. The business is left rudderless, which hurts its value. This is a lose-lose situation. The parties will want to negotiate a solution. Well-crafted exit and termination provisions can provide a starting point from which the parties can negotiate a solution that they might not otherwise be able to reach in the absence of these provisions.
DEFAULT AND CHANGE IN CONTROL
In addition to deadlock situations, if one party materially breaches the joint venture agreement, the other party will usually be entitled to trigger exit provisions. For example, in a situation where the parties have previously agreed to make certain capital contributions, but later one party is unable or unwilling to do so, the other party may no longer wish to continue working with the defaulting party.
The terms of the exit in a default or change-of-control scenario usually vary from those of the deadlock situation, because one party is at fault. In the case of a default, the nondefaulting party can decide whether to buy out the other party or sell its own interests under a buy-sell provision. Alternatively, the non-defaulting party may decide to invoke dissolution of the joint venture (see below, Documenting the Exit or Termination).
A change of control of one party is often treated similarly to a default. The identity of the joint venture partner is often important enough to trigger exit rights in favor of the party not experiencing the change in control. A party may be reluctant to agree to create these optional rights for any change in control. It might argue that creating these rights in favor of its joint venture partner in response to any change in control is a windfall when the identity of the new controlling party is no threat to the joint venture.
This provision is often the subject of detailed negotiations that might limit exit rights to situations where the acquiring party is a member of a specific group of competitors, or is an entity engaged in a certain category of business activities.
COMMON ARGUMENTS AGAINST EXIT AND TERMINATION PROVISIONS
Although there are many arguments for including exit or termination provisions, some JV parties decide to remain silent about this in the joint venture agreement.
Common arguments against including exit or termination provisions include the following:
- They make it too easy to abandon the joint venture.
- They are too hard to negotiate and are unlikely to be used.
- They cannot be properly drafted at the outset to cover issues emerging later.
One party may manipulate the provisions to take advantage of a weakness in the other. For example, if one JV party is much smaller and has less capital available than the other, the stronger party could cause a deadlock to occur in hopes of triggering a buy-sell provision where it can buy out the other JV party at a price below what the other would voluntarily accept.
Although these are legitimate concerns, thoughtful exit provisions customized to the specific facts of the proposed joint venture can address them. The provisions can:
- Reduce uncertainty and create a level playing field.
- Allow the parties to implement rules for ending their relationship designed to maximize the value of the joint venture.
Even if the mechanisms envisioned by the provisions are not used (which often turns out to be the case), this does not mean the provisions are not valuable or important. The fact that the provisions are present and can be invoked is often enough to cause the parties to work through key issues, such as valuation, that otherwise might have mired them in inaction.
WHAT IF PARTIES DO NOT PROVIDE FOR AN EXIT?
Failing to provide well-crafted exit provisions often leads to inefficiency and delay in resolving the situation, resulting in lost value. However, if the parties do not provide mechanisms for dealing with a deadlock, applicable law can be used to address the situation.
For example, the Delaware General Corporation Law (DGCL) provides that the Delaware Court of Chancery may appoint a custodian when, for example, the “business of the corporation is suffering or is threatened with irreparable injury because the directors are so divided respecting the management of the affairs of the corporation that the required vote for action by the board of directors cannot be obtained and the stockholders are unable to terminate this division” (DGCL § 226).
In the case of a Delaware LLC, the Delaware Limited Liability Company Act (DLLCA) provides that “on application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement” (DLLCA § 18-802).
However, a court-appointed custodian or court-ordered dissolution can lead to a protracted dispute and loss of value of the joint venture.
A 2009 Court of Chancery case illustrates what can happen when there are no express exit provisions. In Fisk Ventures, LLC v. Segal, Fisk Ventures’ operating agreement called for a board of five managers to manage its affairs, but with many actions subject to the approval of 75% of its members. The court noted that the history of the company showed it suffered from a state of virtually perpetual deadlock. The lack of good exit provisions appears to have contributed to over five years of discord before one of the members finally sought judicial dissolution. In its decision, the court highlighted the compelling argument for including express exit provisions, stating, “This case involves a long-lived corporate dispute that resulted in devastating deadlock to [the company’s] Board and the loss of significant value to all involved. [The company’s] Board is hopelessly deadlocked, and the LLC Agreement fails to anticipate that risk by prescribing a solution to the Board conflict” (Fisk Ventures, LLC v. Segal, 2009 WL 73957 at *16 (Del. Ch. Jan. 13, 2009)).
DRAFTING AND NEGOTIATING EXIT AND TERMINATION PROVISIONS
KEY EXIT AND TERMINATION PLANNING ISSUES
When contemplating exit or termination provisions in a joint venture agreement, preliminary questions to consider include:
- Under what circumstances may a party trigger a buy-sell mechanism or dissolution?
- Who is entitled to commence the exit procedures? What are the mechanics to do so?
- What are the consequences of each of the following scenarios on the full array of other joint venture relationships?
- Consummation of a buyout following deadlock.
- Commencement of dissolution following deadlock.
- Consummation of a buyout following default or change in control.
- Commencement of dissolution following default or change in control.
In addition to the procedures and financial terms embedded within the exit and termination provisions, the parties will also need to contemplate the impact of these actions on other issues:
- What happens to employees who may have been contributed or seconded by the exiting party?
- What intellectual property licenses survive (considering both inbound to, and outbound from, the joint venture)?
- Is it appropriate to make any modifications regarding exclusivity, royalties, and field-of-use provisions that should be automatically triggered on the exit or termination (known as springing modifications)?
- Are there other critical assets or regulatory licenses that require special treatment?
- Will noncompetition agreements survive? For how long?
- What happens to distribution and supply arrangements among the parties and their affiliates?
How will regulatory requirements affect the contemplated exit provisions (for example, the need to comply with Federal Communications Commission, Hart-Scott-Rodino, and foreign investment, ownership, and control regulations)?
DOCUMENTING THE EXIT OR TERMINATION
The most common forms of joint venture entities used are LLCs and corporations. In the case of an LLC, the LLC agreement (also referred to as the operating agreement) usually contains the provisions relating to governance of the company, along with the exit and termination provisions. In the case of a corporate joint venture, some governance provisions are in the bylaws and certificate of incorporation, but there is also usually a stockholder’s agreement containing additional governance provisions, along with the exit and termination provisions.
The most common forms of exit and termination provisions are:
- Escalation and mediation.
- Mandatory dissolution.
Escalation and Mediation Provisions
When a deadlock arises in a joint venture, the first step to try to resolve it is often an escalation procedure. An escalation provision applies when the issue has already been discussed by the board of directors (in the case of corporations) or the board of managers (in the case of LLCs), but has not been resolved. A party that wishes to break the deadlock must provide notice to the other party, and then the issue is submitted to specified high-level officers of each JV party. Those officers will then be required to attempt to resolve the deadlock for a specified period of time.
In some cases, mediation might be used to aid this attempt at dispute resolution. In other cases, the nonbinding mediation is replaced by allowing the mediator to act as an independent expert who resolves the dispute in a binding manner with his or her own decision or by acting as a neutral tie-breaker and siding with one party or the other.
However, this binding approach is somewhat rare and can be problematic because using an independent expert is better suited to resolving factual matters than to making complex business judgments. For example, imagine a joint venture governing body that is deadlocked over whether to admit a new strategic partner to the joint venture, or whether to raise additional equity funds under a new series of preferred equity with terms on which the parties cannot agree. These are not the types of decisions for an outside expert, even if the expert is a business executive with excellent industry experience.
Key issues to consider when drafting and negotiating escalation and mediation provisions include:
- What types of deadlock issues should be subject to escalation?
- To whom will matters be escalated?
- What length of time should be required to allow escalation to potentially resolve the dispute before moving on to the next option to break the deadlock?
- What types of deadlock disputes are appropriate for mediation?
- If mediation is chosen, should there be a single mediator or a panel?
- What type of credentials should the mediator have? Should it vary depending on the specific issue?
A buy-sell provision is often used in connection with a deadlock. It is also often used, with certain modifications, if the other party materially breaches a joint venture agreement or experiences a change in control. A buy-sell provision is intended to result in one JV party buying the other out. Therefore, when the buy-sell provision is invoked, it ends the deadlock by removing a party from ownership in the joint venture.
In nondefault situations, the buy-sell provision can be invoked by either party, usually after an attempt at resolution through escalation to senior executives of the JV parties has proven unsuccessful. Many times, the buy-sell provision cannot be invoked during an initial specified period of time, such as the first two years of the life of the joint venture. The rationale is that the parties should have some minimum level of commitment to the joint venture before an exit procedure is permitted. The initial business plans and budgets should be adequate to allow the parties to work through any disagreements during this initial phase of the life of the joint venture.
In a default situation, the nondefaulting party may invoke the buy-sell provision after any applicable cure period passes and the default has not been remedied.
Key issues to consider when drafting and negotiating buy-sell provisions include:
- Who will buy and who will sell?
- How will the purchase price be determined?
- When will payment be required?
- What happens to each of the other material agreements among the JV parties and affiliates, such as:
- intellectual property licenses?
- supply agreements?
- distribution agreements?
- credit agreements?
- credit enhancement arrangements?
The joint venture drafting process allows for a great deal of creativity, so there are numerous variations of buy-sell mechanisms. For two common approaches to addressing deadlocks, see Box, Buy-Sell Mechanisms.
Some of the buy-sell mechanisms can also be used when a JV party is in default. In this case, the non-defaulting party can typically decide, at its option, whether to be the buyer or the seller. The price will need to be set by an appraisal mechanism. If the nondefaulting party elects to buy, the agreement can provide additional concessions to the buyer, such as allowing the buyer to pay over a period of years with a promissory note. In this situation, agreements sometimes also provide an option for a bargain purchase by the buyer. However, a bargain purchase in this situation may not be enforceable, and there is a risk that it could be interpreted as liquidated damages and an election of remedies. For example, the ability to buy out the defaulting JV party at 70 or 80 cents to the dollar of appraised value could be viewed as the equivalent of financial compensation for the breach (in other words, the defaulting party has “paid” damages by surrendering an asset worth, for example, $10 million for $8 million).
One cannot predict damages based on a default occurring in the future. Accordingly, the ability to choose to buy, at fair market value (rather than at a discount to the appraised fair market value), with a note payable over several years, while retaining all rights to remedies for the underlying default, is likely preferable to speculating that the discount is substantially equivalent to the damages arising from the applicable default.
Mandatory Dissolution Provisions
Joint venture agreements often have mandatory dissolution provisions. A mandatory dissolution provision is sometimes used instead of the buy-sell approach. Parties may believe that if a deadlock exists, rather than going through a buy-sell procedure, the business should be sold, either as a going concern or otherwise, with the individuals managing the dissolution tasked with maximizing the proceeds. The JV parties are typically permitted to participate as potential purchasers, along with third parties.
More often, the mandatory dissolution procedures can be used as a second option to the buy-sell provision. In a deadlock situation, it can also be a useful backup if the buy-sell procedure does not result in either party buying the other out, but the deadlock continues as a threat to the prospects of the joint venture. Alternatively, if a partner of the joint venture is in default, the nondefaulting party may prefer dissolution and want the right to exercise that option in the first instance.
Key issues to consider when drafting and negotiating mandatory dissolution provisions include:
- Who controls the process?
- What standards should apply to the controlling party’s conduct? For example, should the controlling party have to use commercially reasonable efforts to maximize the sales price? How widely does the business need to be marketed and for how long?
- How should the process differ if it is invoked as a result of a party’s default? For example, the non-defaulting party should probably be given control of the dissolution process, but subject to some protections against abuse by such controlling party.
- Are there any circumstances under which the JV parties should not be allowed to participate as potential purchasers?
- Should an auction process be defined in advance?
- If there are ongoing disputes, should the dissolution proceeds be paid into escrow pending the resolution of the disputes?
- What happens to each of the other material agreements among the JV parties and affiliates, such as intellectual property licenses, supply agreements, distribution agreements, credit agreements, and credit enhancement arrangements?
Mandatory Dissolution Mechanics
Mandatory dissolution provisions are highly fact-specific and must be well integrated with the other features of the agreement, especially any buy-sell, default, or remedial clauses. They must also work properly with ancillary agreements, such as intellectual property licenses.
Following are two examples of how a mandatory dissolution provision could be structured:
After a default and the applicable cure period, the nondefaulting party may cause the dissolution of the entity. The nondefaulting party would oversee and control the dissolution procedures.
In a deadlock situation, following the inability to resolve the deadlock through any other alternative provided in the agreement, either party may cause the dissolution of the entity. Either a specified officer or a specified committee of individuals may be required to manage the dissolution.
In either case, those managing the dissolution would be subject to a duty to act reasonably promptly and with a view to maximizing the proceeds of the disposition of the entity’s assets. Additional provisions could also be included, such as requiring the retention of an investment banker who would engage in an auction of the business and make recommendations as to which bid is superior. The parties would be required to pay any amounts owed by them to the entity. The proceeds of the disposition of the entity’s assets would be applied to:
- Reimbursing the costs of the dissolution process.
- Paying third party creditors.
- Paying debts owed to the parties.
- Distributing the remaining proceeds in accordance with the parties’ equity percentages or capital accounts, as applicable.
The party, officer, or committee managing the dissolution would prepare and deliver to the parties a statement with a final accounting.
MoFo partner Tim Harris explains what distinguishes a follow-on round from an initial round of financing, including the relationship between Series A and Series B investors in a follow-on round and how these relationships inform future series of investors.
Watch this video to learn more.
There are four primary forms that a startup business can take: (1) sole proprietorship, (2) partnership, (3) limited liability company, and (4) corporation. We have described the pros, cons, and principal features of each of these business forms below.
1. Sole Proprietorship
A sole proprietorship is the default arrangement for any individual conducting a business that does not take any other action to form a separate legal entity. There are no formalities that must be followed to be a sole proprietorship, and the entrepreneur has complete control over the business. A sole proprietorship is simple and inexpensive to form, and there is no separate taxation on business earnings (i.e., the entrepreneur pays all taxes). The entrepreneur bears personal liability for all business obligations.
A sole proprietorship is an unattractive arrangement for conducting a startup for the following reasons:
- there is no ability for shared ownership or equity incentives (co-founders, investors, or employees);
- there is no ability to raise equity capital (founder investment or founder borrowing only);
- there is a limited ability to enjoy capital gains on acquisition of a business (asset sale only); and
- there is no entity to sell in an acquisition or initial public offering.
A partnership is two or more persons conducting a business. A partnership is the default arrangement when multiple entrepreneurs take no action to form a separate legal entity. The partnership agreement among the partners can be oral or in writing. There is no separate taxation on business earnings of a partnership. Instead, all partners individually pay all taxes.
There are two types of partnerships: general partnerships and limited partnerships. In a general partnership, all partners are active in the conduct and management of the business and are jointly and severally liable for all partnership obligations. In a limited partnership, general partners are active in the conduct and management of the business and are jointly and severally liable for all partnership obligations; limited partners do not participate in the conduct and management of the business and enjoy limited liability for partnership obligations up to the extent of their investment. In any partnership, the allocation of profits, losses, and distribution of cash can be complex and burdensome.
A partnership can be an unattractive arrangement for conducting a startup for the following reasons:
- shared ownership and equity incentives can be complex and burdensome; and
- it can be difficult to raise equity capital because there can be investor reluctance to being liable for partnership obligations.
3. Limited Liability Company
A limited liability company is formed by filing articles of an organization or a certificate of formation with state authorities. The members of the limited liability company enter into a written limited liability company agreement or operating agreement. A limited liability company is owned by the members, with their ownership being represented by either “units” or “percentage interests,” and the company’s operations are managed by either members or managers. Members are protected from personal liability for business obligations. There is no separate taxation on business earnings; instead, members pay all taxes.
A limited liability company can be an unattractive vehicle for conducting a startup for the following reasons:
- the issuance of K-1 tax forms to each member each year can be burdensome to the startup;
- there are investor limitations on the ability to invest in “flow through” entities such as limited liability companies; and
- in an initial public offering, the equity markets will demand conversion to a corporation.
A corporation is formed by filing a certificate of incorporation (in Delaware) or articles of incorporation (in California) with state authorities. A corporation is owned by shareholders, operated by officers, and overseen by a board of directors. Shareholders are protected from personal liability for business obligations. A corporation generally has a separate taxation on business earnings, and formalities must be observed to maintain existence and shareholder protection from liability for business obligations.
A corporation is an attractive vehicle for conducting a startup for the following reasons:
- venture capital investors generally prefer making an investment in preferred stock of a corporation;
- all shareholders are bound by non-contractual charter documents that are approved by the requisite number of holders (even if not unanimous); and
- an initial public offering generally is conducted through a corporation (with the issuance of common stock).
Intellectual property, or IP, is the lifeblood of a technology startup company. IP enhances a startup’s enterprise value by providing (1) a competitive advantage (other companies can be excluded from using your company’s IP); (2) differentiation from legacy solutions and competition; and (3) the ability to extract license fees or royalties. IP can be protected under a variety of legal doctrines – namely patents, trade secrets, copyrights, and trademarks.
A patent provides the right, for a limited period of time, to exclude other parties from exploiting an invention. In order to be patentable, an invention must be novel (no prior art), useful, and non-obvious. Potentially patentable inventions include compositions, machines, methods, software, and business methods. Patent protection in the U.S. can be obtained by application to the U.S. Patent and Trademark Office, or PTO. Once issued, a patent can be monetarily exploited by suing third parties for infringement or obtaining licensing fees based on third-party use of the patent.
Patent applications can be provisional or nonprovisional. This is an important distinction, as nonprovisional patent applications can ultimately result in issued patents, whereas provisional patent applications must be refiled as nonprovisional within one year of filing in order to result in an issued patent.
Why do many startup companies choose the provisional patent application route? Provisional patent applications are confidential and not available until refiled as a nonprovisional application and made public. Additionally, the fees for filing a provisional patent application with the PTO are less than the fees for filing a nonprovisional.
Many startup companies rely on trade secret protection in order to safeguard their IP until the time comes to file a patent application. A trade secret is any confidential information that derives value from not being generally known or readily ascertainable by others who could obtain value from its disclosure or use, and that is subject to reasonable efforts to maintain its secrecy. Formulas, compilations, programs, devices, methods, techniques, and processes are all types of IP that can be subject to trade secret protection. A startup company should take efforts to maintain the secrecy of its IP by controlling access to the IP, marking the IP as confidential and requiring individuals and entities that receive access to or disclosure of the IP to sign confidentiality agreements. In contrast to patent protection, trade secret protection lasts as long as the information remains a secret.
Copyright protection is afforded to original works of authorship (not ideas) that are fixed in a tangible medium. Examples include writings, music, movies, and computer programs. In the case of individuals, copyright protection lasts for the life of the author plus 70 years. In the case of corporations, e.g., works made for hire, copyright protection lasts 95 years from first publication. The fair use doctrine allows third parties to use copyrighted material under limited circumstances, and whether such use is “fair” will require an examination of the purpose, the amount of work used, and the effect on the value of the copied work.
A trademark is a word, name, design (including product design) or distinctive symbol (logo) used in commerce to designate the origin of a particular good or service and distinguish it from other goods. The first trademark many startup companies obtain is their company name. In order to determine whether the proposed mark is available for trademark protection you should first search other usage of the mark. Assuming there are no obvious issues, you then need to file an intent-to-use application, use the trademark in commerce, and complete the application for registration. You can then use the mark TM or ®.
The test for determining whether your mark infringes on another mark is whether it will cause confusion in the marketplace. Trademark protection will last as long as you use the mark; however, if a mark becomes “generic,” i.e., synonymous with your company, then you can lose trademark protection. Notable examples of once registered trademarks that died due to becoming generic include Aspirin, Escalator, and Thermos.
A startup company should develop an IP strategy in consultation with its IP counsel. Protecting your company’s most valuable assets is essential, and potential investors will also expect to see adequate IP protection measures in place before providing your company with any funding.
MoFo partner Tim Harris explains founder restricted stock, including how these stocks benefit the company and the founder.
Watch this video to learn more.