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When entrepreneurs and founders approach Parsons Lift about raising capital for their business, I often discover that they have failed to take fundamental steps to properly set up the business. Missing these initial steps results in additional time and expense, as we work to ready the business to be presented to potential funders or strategic partners. Below are some early-stage protections and basic steps to consider to facilitate a better capital-raising process.
Form the entity
An important initial step is to actually form an entity. This creates protections for the founder from personal liability for the business’s operations. It also creates a structure to conduct business. The decision to initially form a business as a corporation or limited liability company (LLC) is driven by tax planning and other business goals, including the anticipated entity governance structure. The business may change form later as it evolves and its needs and requirements change.
If outside funding will be sought early in the process, establishing the business as a corporation may be more appropriate, since that is a more familiar and frequent vehicle for outside investors. Also, investors often shy away from entities that are ‘pass-through’ for tax purposes. Creating a corporation also allows early shareholders to take advantage of qualified small business stock treatment, if applicable. Alternately, establishing a business as an LLC allows for increased flexibility and customization for negotiated terms between the owners as well as avoiding double taxation at the entity and owner level.
Regardless of the entity type, founders must ensure they utilize appropriate formation and governance documents. For a corporation, this includes articles of incorporation, bylaws and often a shareholder agreement. For an LLC, an operating agreement among the members will include important governance and tax provisions. In Utah and many other states, it is extremely important that members of an LLC establish a comprehensive operating agreement, as the default rules under a state’s LLC statute are often undesirable and do not reflect desired commercial terms.
Issue founder equity and plan the cap table
Founders need to define their ownership rights and the consideration paid for receiving equity in the entity. At this stage, the founders should contribute intellectual property and business concepts to the enterprise so that the enterprise actually owns the business concept. This can be documented through contribution agreements and invention assignment agreements and will provide comfort for an investor that the company owns and can pursue the planned business.
As part of the formation process, a founder should consider the business’s equity structure. How much equity will be held by the founders? By employees? By third-party investors? What securities should be authorized and what rights should go along with securities to be issued to investors? As part of this process, a founder needs to acknowledge that the founder will face dilution as other parties are brought into ownership. In a corporation, this can be addressed somewhat by a shareholders’ agreement that includes voting provisions defining the composition of the board as well as what votes are required for specific action items. The agreement will also detail how shares can ultimately be transferred and provide the company and the other shareholders the right to remove shareholders who do not contribute to the company or do not perform as intended by the parties.
Define employee equity
Early on, a business should determine what equity may be offered and held by employees. Companies may use equity compensation as a mechanism to reward employees, particularly when they may not have revenues or available cash to pay cash bonuses to employees. A business offers equity to employees to align the interests of the employees and provide incentives to grow the company’s value. Equity should be provided to employees in conjunction with obtaining intellectual property rights and placing restrictive agreements on the employee for confidentiality and other restrictions to protect the company. Employee equity can be subject to forfeiture or clawback if the employee doesn’t continue employment with the company or violates restrictive covenants.
The nature and type of equity incentives will vary depending on the stage and value of the company. In an early stage, restricted stock may be awarded because this will have fewer tax implications for the employee and will result in direct ownership. Stock options are also a possibility at this stage or at later stages. Stock options allow employees to lock in the purchase price for the stock at an early value.
To properly implement employee equity incentives, the company should implement a broad-based award plan that gives the company flexibility in determining equity awards and terms as the company grows and matures. This will be important to present to investors as part of the company’s plan for growth.
Protect the intellectual property
A primary diligence matter for investors will be to review the intellectual property (IP) of a business. Protecting IP rights should be a paramount consideration for founders. A company should make sure it carefully documents IP creation and protection. Each employee involved in the creation of IP should be required to execute IP assignments to ensure that the company owns any IP created on behalf of, or in connection with, the company’s business. The company should also require each contractor and third party involved with IP to execute appropriate assignment and ownership agreements. Even if a contractor creates IP as the result of a direct engagement by a company, the contractor will own any resulting IP unless the contractor executes appropriate assignment and ownership agreements. As part of this process, employees and contractors should be required to confirm that any created IP does not belong to any third party and that any such IP has been independently created.
In implementing an IP protection program, a software business should define policies that determine when open-source code can be used and ensure that all licenses are appropriately followed. Investors and buyers will be especially concerned to make sure the company is not violating these or any other software licenses.
Sign the documents
It may seem obvious, but a business needs to ensure that all of the carefully-prepared documents and agreements are fully executed and maintained in the company’s records. Unfortunately, it is not unusual to discover that a company has either failed to have its documents executed or cannot locate the documents that were actually assigned. In those situations, a company may find that its supposed rights are unenforceable, and its business is unprotected, diminishing the company’s value.
Founders often find that conferring with legal counsel in the early stages of establishing a company can save time and money later – as well as alleviate the stress of learning too late that the company is not adequately protected and is unable to implement its next business steps.
About Shane L. Hanna
Shane L. Hanna is a deal attorney at Parsons Lift and a shareholder at Parsons Behle & Latimer with more than 25 years of experience. Shane regularly assists clients with the formation and organizational matters, corporate governance, debt and equity financings, securities matters, mergers and acquisitions, technology transactions and other matters. Learn more here.