Legal Landmines

What to Know When Starting Your Start-Up

Jackie Falk

March 24, 2016

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Categories of Most Common (and costly)

Mistakes

• Choice of Legal Entity

• Founders’ Equity

• Protecting Intellectual Property (IP)

• Fundraising

• Employees v. Independent Contractors

• Compensating Employees

• Working With (Managing) Legal Counsel

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Choice of Legal Entity

• Typical Entity Alternatives:

• Limited Liability Company

• Subchapter C Corporation

• Considerations:

• Tax

• Liability

• Number and Types of Owners

• Funding Plans

• Complexity/Administration

• Cost

Which type of entity should we choose?

Most common: Delaware C-Corp

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Choice of Legal Entity

Pros Cons

LLC • Tax benefits

• Flexibility of management

• Flexibility of economics

• Not standard for VC

• Tax benefits rarely used

• Higher legal, accounting

costs

• Employee equity not easy

C-Corp • Preferred for VC

• Decades of established

law

• Lower legal fees

• Equity incentives are easy

• Double taxation

• Follow corporate formalities

• Not as flexible

Other forms (not as common) :

B-Corp, S-Corp

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Founders’ Equity

• Authorized v. Issued Stock

• Promising a set ownership percentage

• Complicating the capitalization table

• Shares not subject to vesting

• Missing the filing deadline for 83(b) elections

• Failing to comply with securities laws

• Waiting too long to issue equity to founders

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Protecting Intellectual Property

• Founders, employees, consultants not assigning IP

• Using third party IP without a license

• Failing to adequately protect trade secrets

• Not addressing IP developed when employed by

someone else

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Employee Compensation

• Failing to adopt an appropriate equity incentive plan

• Creating stock valuation problems (409A)

• Vesting and acceleration, revisited

• Post-termination acceleration

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Capital Raising

• Having a poorly articulated pitch

• Misunderstanding financing structures and/or terms

• Not doing “due diligence” on the investor

• Utilizing a “finder” to secure investments

• Failing to comply with securities regulations

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Raising Capital: Preferred Stock

Preferred Stock

• Pros

• Some investors insist upon a “priced” round

• Can use standard terms

• Cons

• Need to set a valuation

• High transaction costs

• Gives up too much control to a seed investor for too little money

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Raising Capital: Convertible Debt

Convertible Debt

• Pros

• Quick

• Low transaction costs

• No current valuation

• Cons:

• Ultimately issuing more preferred

• Converts at a discount in the next round

• Often includes a “cap” on conversion price into next round

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Raising Capital: Safe

Safe

• Pros

• Quick

• Low transaction costs

• No current valuation

• Cons:

• Converts at a discount in the next round

• Often includes a “cap” on conversion price into next round

• Pro-rata rights are part of the standard template

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Independent Contractors and Interns

• Substantive (20 factor) test

• Misclassifying employees as “independent

contractors” or “consultants”

• Income tax obligations (W2 v. 1099)

• Back taxes, penalties and interest

• Classifying anyone you can’t afford to pay as an

“intern”

• School credit

• Back taxes, penalties and interest (yes, it applies here too)

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Working With (Managing) Legal Counsel

• Hiring a lawyer who has no start-up experience

• Hiring a lawyer who has some start-up experience

• Allowing too many (legal) cooks in the kitchen

(“over-lawyering”)

• Over-complicating the incorporation process

• Failing (or being afraid) to seek advice

• Managing (or mismanaging) expectations and costs

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Questions? Contact:

Jaclyn L. Falk| WilmerHale

950 Page Mill Road

Palo Alto, CA 94304 USA

+1 650 600 5037(t)

Jaclyn.Falk@wilmerhale.com

Visit www.WilmerHaleLaunch.com

Follow @WHLaunch