Legal resources for all types
Business Formation |Raising Capital | Intellectual Property
Business Formation
Potential benefits of forming a legal entity such as an LLC or Corporation include: (i) liability protection, (ii) potential tax savings, and (iii) the opportunity to share ownership with staff/employees through equity compensation.
Speaking generally, there are three different paths entrepreneurs will choose when forming a for profit legal entity.
LLC
Unlike a corporation, an LLC is product of contract law and therefore allows the business to setup an ownership structure that makes sense at both the business and the tax level. Profits and distributions need not mirror the percentage ownership of each owner, and the company need not be managed by a board of directors, or hold regular meetings.
The formalities and obligations of a corporation can be burdensome for a solo entrepreneur, and an LLC does not require the owner to setup a board of directors, hold shareholder meetings, keep record of meetings, and generally operate at a higher level of state regulatory compliance.
If an LLC is owned by one member it will be taxed as a “disregarded entity”, which means the IRS will tax the owner on a Schedule C like a sole proprietorship, and all profits and losses will flow down directly to the owner (one level of tax). If the LLC is owned by multi-members, the default tax structure is a partnership.
Finally, setting up an LLC requires less steps than forming a corporation, making it more cost effective to gain the limited liability an entrepreneur may desire, while also receiving favorable tax treatment.
Corporation (S-Corp)
The important thing to understand is that an “S-Corp” is not a legal entity, rather, it is a tax structure. Thus, even an LLC can elect to be taxed as an S-Corp. However, speaking generally, when someone says ‘I’m an S-Corp” what they mean is they’ve formed a corporation that has elected to be taxed as an S-Corp.
The S-Corp tax structure is a popular model for small businesses because the profits and losses flow through to the owners (you’ll often hear people say “pass through taxation”), which means there is only one layer of tax. However, unlike an LLC or standard C-Corporation, an entity taxed as an S-Corp can only have 100 shareholders, and all of the shareholders must be natural people (meaning not another legal entity) who are also US residents. Additionally all shareholders must own the same class of stock which means that you cannot have a “preferred” class of stock for investors or the founding owners.
Whether or not remaining a sole proprietorship, forming an LLC, or creating a corporation taxed as an S-Corp makes sense for your business depends heavily on (i) the type of business, (ii) how the business will grow and evolve over the years from an ownership, profit and employee standpoint, and (iii) if the business will need to infused with capital in the near future. You are strongly encouraged to speak with an experienced attorney to help get you setup for success.
Corporation (C-Corp)
If your company is considering raising venture capital down the road, most VC firms will demand a C-Corp structure. The reasons investors will not want to get involved with a pass through entity such as an LLC, or entity taxed as an S-Corp is because (i) VC funds often take money from large organizations (such as pension funds) and they are prohibited from investing the money in a pass through entity, (ii) wealthy individuals will not want to have their personal tax equation messed up by having to wait for your K-1 tax return to allocate the company’s profit and losses to the owner based on the investors ownership percentage, and (iii) if the company plans to reinvest profits, the investors would prefer to not have to be personally taxed on the profits as an owner.
For example, if you own 5% of an LLC or entity taxed as an S-Corp and the that company makes $200,000 in profit, the 5% owner would need to report $10,000 (5% of $200,000) in income on his/her/it’s personal tax return. It does not matter whether that $10,000 was distributed to the owner. This is known as “phantom income” and can obviously cause problems and is why the C-Corp structure makes a lot of sense when raising capital from VCs.
Raising Capital
What is a “Private Placement”?
A private placement or a private offering is a fund raise, or capital raise that has not been registered with the SEC. A private placement typically consists of either a debt or and equity offering, or a convertible instrument such as a SAFE agreement that will convert into equity when the company raises a larger round of funding (such as a Series A).
Here’s a general list of information you’ll want to have prepared before you can start a raise. Some of these bullets are discretionary, but the more you can check off the better:
Company formation
Structuring the offering: will you offer, debt, equity, or a convertible instrument such as a SAFE?
Investor questionnaire to vet prospective investors (not everyone is permitted to invest in a private offering)
Business plan, executive summary and financial projections
Term sheet, and offering documents including but not limited to subscription agreement along with board and shareholder resolutions
File the necessary security exemption with the SEC and each state you take money from
Execute investment documents and close the round
Series Seed Round: The Convertible Note vs the SAFE Agreement
(1) Both Convert to Equity
The goal of both a SAFE and a Convertible Note (CN) is to delay the valuation discussion until the company is more established and can properly fight for a fair shake when it comes to valuing the company's stock. Thus, the SAFE and CNs are convertible instruments that will convert into equity when the startup looks to raise a bigger round of fundraising (such as a Series A) 12-24 months down the line.
(2) Simplicity (Legal Costs)
The SAFE agreement is a five page document drafted by YCombinator, and you rarely see much deviation in the standard terms, which means overall it is likely to yield lower legal fees as a note can have a variety of unique provisions when compared with another startups CN raise.
(3) Key Features
Both the SAFE and the CN provide a discount on the price within the next round (such as 20%), which means that if the startup sells Series A stock for $1, the SAFE or Note Holders are allowed to convert in at $.80 per share.
However, a SAFE is not a debt instrument and so unlike a CN the holder of a SAFE will not earn interest on the principal while it remains outstanding. This also means there is no maturity date. While this is great for the startup, it's less attractive for the investor.
(4) Valuation Cap
As mentioned, the goal is to not get into the weeds as to the value of the startup during the seed stage round, however, both the SAFE and the CN allow for a "valuation cap" so that either instrument will not convert at a value about X (e.g. $5 million). More and more you're seeing investors demand such a protection.
(5) Change of Control
Both instruments allow for mechanisms that would allow the investor to be paid back with some perks if in fact the startup was to be acquired.
So what's best?
As the above points out, from the entrepreneur/startup's perspective, the SAFE is a much more appealing setup because the principal amount does not earn interest, and there is no ticking time bomb of a maturity date. However, unless you're simply raising money from friends and family who would invest in you no matter what the terms were, or the idea, you better be a pretty attractive idea/company for a sophisticated/professional investor to agree to the terms of a SAFE, otherwise, a traditional CN is much more attractive as it allows the investor to earn interest, and have some leverage if the maturity date occurs.
Intellectual Property
Trademarks, copyrights, and patents protect different types of intellectual property and each can play an important role in protecting and growing your business. A trademark typically protects brand names and logos used on goods and services. A copyright protects an original artistic or literary work. A patent protects an invention. Each of these intellectual property rights is unique
Trademark
What is a trademark?
A trademark protects your brand. The owner of a trademark may exclude others from creating a likelihood of confusion as to the source or origin of goods or services. Trademark rights may be used to prevent others from using a confusingly similar mark, but not to prevent others from making the same goods or from selling the same goods or services under a clearly different mark.
What is the duration of the right?
Your trademark exists so long as your mark is used in commerce and your fees are paid.
How is the right obtained?
You can establish “common law” rights in a mark based solely on use of the mark in commerce, without a registration. However, owning a federal trademark registration on the Principal Register provides a number of significant advantages over common law rights alone.
How is the right lost?
Your trademark rights can be lost if your mark is no longer in use in commerce, registration renewal fees are not paid, or the mark is canceled or becomes generic.
Copyright
What is a copyright?
Copyright is a form of protection provided to the authors of "original works of authorship" including literary, dramatic, musical, artistic, and certain other intellectual works, both published and unpublished. The owner of a copyright may exclude others from reproducing, preparing derivative works, distributing, performing, or displaying copyrighted works.
What is the duration of the right?
Your copyright lasts for the life of the author plus 70 years.
How is the right obtained?
The right begins when a work is fixed in a tangible medium of expression. However, federal registration secures your ownership to the copyright with official government documentation of your right. Copyrights are registered by the Copyright Office of the Library of Congress.
How is the right lost?
After the life of the author plus 70 years, your copyright expires.
Patents
What is a patent?
Your right conferred by a patent grant is the right to exclude others from making, using, offering for sale, or selling a patented invention in the United States or importing a patented invention into the United States. What is granted is not the right to make, use, offer for sale, sell or import, but the right to exclude others from making, using, offering for sale, selling or importing the invention. Once a patent is issued, the patentee must enforce the patent without aid of the USPTO.
What is the duration of the right?
Generally, the term of a new patent is 20 years from the date on which the application for the patent was filed in the United States or, in special cases, from the date an earlier related application was filed, subject to the payment of maintenance fees. U.S. patent grants are effective only within the United States, U.S. territories, and U.S. possessions. Under certain circumstances, patent term extensions or adjustments may be available.
How is the right obtained?
Your patent is granted if the UPSTO issues a Grant of Letters Patent.
How is the right lost?
Your patent term expires.
