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Below are ten tips for entrepreneurs who are launching a start-up that will seek
venture capital (“VC”) financing.
3. Incorporate and Issue Stock ASAP. The venture should be incorporated and
stock should be issued to the founders as soon as possible -- i.e., before the company has
any significant value. Clearly, as milestones are met by the company subsequent to its
incorporation (e.g., the hiring of employees, the signing-up of customers, the creation of a
prototype, etc.), the value of the company will increase and therefore so will the purchase
price of the stock (which could trigger significant taxable income to those founders
receiving stock in exchange for past or future services). Moreover, if a founder intends to
transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of
the Internal Revenue Code (which permits a tax-free exchange under certain conditions)
may only be available at the time of incorporation and not later after more stock has been
issued. Indeed, the same principle applies with respect to the issuance of stock
options/equity to employees: the goal is to do it as soon as possible when the value of the
company is as low as possible.
6. Comply with Applicable Federal and State Securities Laws. A company may
not offer or sell its securities unless they have been registered with the Securities and
Exchange Commission and registered/qualified with applicable state commissions.
Fortunately for the start-up, however, there are certain prescribed exemptions which may
be applicable, including Section 4(2) of the Securities Act of 1933, as amended (the
“1933 Act”), and Regulation D promulgated thereunder (as well as Rule 701 discussed
below). It is indeed imperative that the entrepreneur seek the advice of experienced
counsel prior to the issuance of any securities: non-compliance with applicable securities
laws could result in serious adverse consequences, including a right of rescission for the
securityholders (i.e., the right to get their money back), injunctive relief, fines and
penalties, and possible criminal prosecution. The rule of thumb in this area is to sell
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securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in
reliance on Rule 506, which preempts state-law registration requirements pursuant to the
National Securities Markets Improvement Act of 1996. (Note: anti-fraud rules are still
applicable under Rule 506.)
7. Protect Your IP. For many start-ups, intellectual property (“IP”), such as
copyrights, trademarks, domain names or patents, is their most valuable asset.
Accordingly, a number of steps should be taken to protect IP assets, including (i)
developing a comprehensive strategy for IP; (ii) establishing and implementing IP
policies and procedures -- e.g., concerning proper use of third parties’ IP; (iii) if
appropriate for the business, filing patent applications and registering copyrights,
trademarks and domain names; and (iv) as discussed below, requiring independent
contractors and employees to execute confidentiality and IP/invention assignment
agreements. Many entrepreneurs retain separate IP counsel to address some of the
foregoing issues, particularly where IP protection is significant to the business model.
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exemption from registration for any offer or sale of securities pursuant to certain
compensatory benefit plans and contracts relating to compensation, provided that it meets
certain prescribed conditions. Most states have similar exemptions, including California,
which recently amended the regulations under Section 25102(o) of the California
Corporate Securities Law of 1968 (effective as of July 9, 2007) to significantly liberalize
the requirements under California law to conform with Rule 701. Moreover, under
Section 409A of the Internal Revenue Code, the company must ensure that any stock
option granted as compensation has an exercise price equal to (or greater than) the fair
market value of the underlying stock as of the grant date; otherwise, the grant will be
deemed deferred compensation, the recipient will face significant adverse tax
consequences and the company will have tax-withholding responsibility. The company
can establish a defensible fair market value by (i) obtaining an independent appraisal or
(ii) if the company is an “illiquid startup,” by relying on the valuation of a person with
“significant knowledge and experience or training in performing similar valuations”
(including a company employee), provided certain other conditions are met. (Note:
restricted stock is not subject to Section 409A.) Again, the entrepreneur should seek the
advice of counsel before issuing stock options or other equity.
10. Pay To Play. Based on the foregoing, it is self-evident that now is not the
time for the entrepreneur/founder to try to save money by doing legal work on his own
and/or by relying on printed forms from a web service. Indeed, there are a number of
significant legal issues that must be addressed to protect the entrepreneur and his/her
venture. Moreover, VC firms and/or other outside investors will be doing extensive due
diligence on the company prior to making an investment and, accordingly, it is
imperative that the entrepreneur demonstrate a certain level of credibility and
sophistication. Remember: “starting companies is a lot like launching rockets: if you're a
tenth of a degree off at launch, you may be a thousand miles off downrange.” The Silicon
Valley Edge, edited by C-M Lee, et al. (Stanford University Press 2000), p. 328 (quote by
C. Johnson, Esq.).
Scott Edward Walker is a former big-firm New York corporate lawyer, with 15+
years of sophisticated corporate-transactional and securities-law experience. Mr.
Walker is the founder and CEO of Walker Corporate Law Group, LLC, a boutique
corporate law firm specializing in the representation of entrepreneurs and their
companies, with offices in Beverly Hills and Washington, D.C. You can learn more about
Mr. Walker’s practice at www.walkercorporatelaw.com, and he can be reached at
swalker@walkercorporatelaw.com. Please note that the foregoing article has been
provided by Mr. Walker solely for informational purposes and does not constitute (and
should not be construed as) legal advice in any respect. Mr. Walker expressly disclaims
all liability in respect of any actions taken or not taken based on any contents of the
article. Copyright © 2009 Scott Edward Walker. All Rights Reserved.
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