1 Business Lifecycle: Forming an Entity, Raising Capital, and Business Planning Todd Krieger & Cyrus Daftary 2015 Makeup Class.

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Business Lifecycle: Forming an Entity, Raising Capital, and

Business Planning

Todd Krieger & Cyrus Daftary

2015

Makeup Class

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Agenda Forming an entity Raising capital Business planning Insurance Bankruptcy Questions and answers

Eli Wants to Start His Business

Visits your office and wants help forming his entity.

Where do you start? Find out more about the business Business plan?

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Business Entity / IncorporationPlanning for the future:

Succession planning - who will replace your programmer?

Partial dissolution - what if a partner wants to be bought out.

Future financing - can you plan on going from a sole proprietorship to a publicly-held corporation and what happens in between?

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Issues to consider

Taxation Liability shield Likely source of financing Number of owners Types of owners Types of distributions Likely exit scenario

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C Corporation Liability protection for owners Subject to double taxation – at entity level and

on distributions Distributions of property to owners are taxable No limit on number or type of owners Appealing to venture financing sources Some exit transactions can be structured in a

tax advantageous way (tax free merger)

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S Corporation Liability protection for owners Subject to single level of taxation – no tax at entity

level but tax paid by shareholders Limit on number of owners (100) Limit on type of owners (individuals only; no foreign

persons) Many financing sources cannot participate (i.e.,

venture capital funds) Some exit transactions can be structured in a tax

advantageous way (tax free merger) Limited to one class of stock (other than non-voting

stock)

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LLC Liability protection for owners Subject to single level of taxation – no tax at entity

level but tax paid by owners (members) No limit on number of owners No limit on type of owners Unappealing to many financing sources – LLCs likely

to generate UBTI and be engaged in US trade or business

Generally, no ability for tax free exit transactions Distributions of property to owners are not taxable

transactions Not as well received by the institutional investing

community• Not normally used for venture backed businesses

Documents may cost more to prepare as they tend to be ‘non-standard’

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Limited Partnership Liability protection for some, but not all, owners

(limited partners) No liability protection for general partner Subject to single level of taxation – no tax at entity

level but tax paid by owners (partners) No limit on number of owners No limit on type of owners Unappealing to many venture financing sources –

likely to generate UBTI and engaged in US trade or business

Generally, no ability for tax free exit transactions Distributions of property to owners are not taxable

transactions Not used in many contexts, but common for private

equity funds

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General Partnership No liability protection for partners Subject to single level of taxation – no tax at

entity level but tax paid by owners (partners) No limit on number of owners No limit on type of owners Unappealing to many venture financing

sources – likely to generate UBTI and engaged in US trade or business

Generally, no ability for tax free exit transactions

Distributions of property to owners are not taxable transactions

Public filings are generally not required Not widely used.

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Filing Process

A. Corporation (S or C) – Certificate of Incorporation/Articles of Organization; foreign qualifications

B. LLC – Certificate of Formation/Certificate of Organization; foreign qualifications

C. Limited Partnership - Certificate of Limited Partnership; foreign qualifications

D. General Partnership – no filing required; may file a “doing business certificate”

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Raising Capital: How does Eli fund the venture?

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Debt Financing

Bank loans Unlikely to be obtained unless company is already

financed Avoid personal guarantees

Convertible Debt – Best early stage financing vehicle

Promissory notes that convert into preferred stock, once a financing occurs

Avoids valuation problems Can be used in angel or friends and family financings Simple; low transaction costs; minimum negotiation

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Friends & Family

Limit number of investorsSeek accredited investors onlyStructure (stock vs. convertible debt)Valuation issues

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Angel Investors

Structure (avoid preferred stock)Try to avoid valuing the companyAvoid onerous terms that might prevent a

venture capital financing

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Venture Capital

VC Requirements Strong management team Unique idea IP advantage Big market

Terms Preferred Stock (liquidation preference, dividends, anti-

dilution, etc.) Control (at board and stockholder levels; contractual

rights)

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Other Sources

Government GrantsStrategic Partnerships

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Securities Law Considerations – Selling Unregistered SecuritiesGeneral RuleNumber of InvestorsAccredited Investors vs. Non-AccreditedAvoid general solicitation or advertising

OK if no non-accredited investors and take reasonable steps to verify accredited status

Subject to additional rulemakingConsequences of violations

Rescission rights Could prevent or delay future financings

Jumpstart our Business Startups Act

JOBS act passed in 2012Facilitates equity based crowdfunding and

reduces some small investor restrictionshttps://www.indiegogo.com/

Different from rewards based crowdfunding

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Practice Pointer

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• Participants have little legal recourse if the project fails or they don’t get their reward

• Project may not be completed• Participants need to protect their IP• http://www.insidermonkey.com/blog/the-5-biggest-

kickstarter-scams-that-swindled-backers-donations-333225/

• http://www.kicktraq.com/projects/

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Intellectual Property Protection

Patents, trademarks, copyrights, trade secrets

Ownership of IP All IP must be owned by the company

Protection of IP Confidentiality Agreements Employee Invention and Non-Disclosure

Agreements; Consultant Agreements

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Employee IssuesNon-Competition agreementsAvoid employment agreementsAvoid payment in stock

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Scenario – Giving out SharesPrior to incorporating, Eli’s Tortes has limited $$.They offer vendors written shares in the upcoming

entity in lieu of payment.

100 shares to the flour vendor.

200 shares to the repair company.

50 shares to the delivery service.

Eli Distributes:

15% share to the web page designer.

10% share to the landlord

5% share to the sugar vendor.

Jason Distributes:

What happens after they incorporate, business goes well, and the vendors want to cash in their shares?

Eli’s Tortes

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Business Plans

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Isn’t Business Planning The Client’s Issue and Not Related to the Lawyer?

By understanding the client’s B-plan: Better serve clients / company by seeing the big

picture More opportunity to provide insight Expand legal services for client

More likely to notice potential legal pitfalls.Protect your own interests:

Will the client be able to pay their legal bill?

Law firms use business plans too!

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Why is a Business Plan Necessary? It is not adequate just to have a good idea. A new venture

needs: A strategy / long term plan Capital Good management Industry contacts and luck

Formal plans are often required to obtain financing

WSJ 1/07: “Do Startups Really Need Formal Business Plans?”

A business plan does not need to be a formal 60 page, 6 month project

Analysis, planning, vision, and communication are essential for any venture

http://www.youtube.com/watch?v=zhnEjxsjjuA

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Technology Start-up Companies Have Many Challenges

Market demands quick innovation Today’s technology idea is dated technology in

a year; Patents; Legal constraints can be a minefield; Technology licenses; and Regulatory and safety approval.

There may be more barriers to entry than a decade ago.

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Business Plans Should Create a Roadmap

Executive summary Core strategy defining product Identifying the market opportunity / niche Competition / threats Revenue and expense projections Sources of capital Short and long term plans Management team

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Red flags in a business plan

Get rich quick schemes “Someone will want to acquire the business

after we get it running.” “We’ll devote time to this until the IPO and

retire young.” “We do not have time for market research - I

have heard about this enough on TV. If we do not bring this idea to market soon, someone else will”

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Red flags in a business plan (cont.)

Risks: All of the intellectual capital is in one person. Reliance on uncommitted resources. (“my

cousin said that he would host this for free,” or “I can get a free billboard from a brother-in-law.”)

Management has had no experience. Management compensation is not anticipated

as an expense.

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A few fundamental questionsRealism test:

How did you create your sales projections? What will you do if sales do not meet

projections? How is this different from the competition?

Infrastructure test: How will customers learn about your product? Who will fulfill orders or do the work?

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Client Example

Client calls up with a vague idea and wants to schedule a meeting.

Client and colleagues spend hours developing a ‘mission statement’ instead of business plan. No idea of target market No plan to market services

Idea falls apart within a month.

The Dream Team

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Client Example #2

Clever idea, but perhaps not unique.Client wants legal documents ASAP

Non-disclosure agreement Incorporation documents Contracts for:

• Customers• Programmers• Employees• Content providers

Problem - he has not even figured out his business plan. What does he really need?

Cart Before the Horse

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Client example: Challenges Facing a Start-up (Part 3)

Interesting idea but esoteric.One person’s idea, others have a cursory

understanding.Does the programmer cede his idea to his

corporation letting others enjoy the fruits of his labor?

What do the others have left if the programmer leaves?

One Founder’s Idea

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Client example: Challenges Facing a Start-up (Part 4)

Clever idea. Client asks everyone’s opinion in an effort to get private investment.

Decides a confidentiality / non-disclosure agreement would be helpful.

Can he/she have friends / family sign non-disclosure agreements after the fact?

What if his/her idea is not unique and already public domain?

“Cat is out of the bag”

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Insurance Introduction

How does the entity protect themselves from a catastrophic loss?

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Insurance Counseling

You do not have to be an expert on insurance law to counsel a client doing business online - just know the potential risks.

Understand the basic elements of the policy and look for potential exclusions that might hurt your client.

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Insurance can Protect a Client against Bankrupting Claims

Limelight Productions, Inc. v. Limelite Studios, Inc. (60 F. 3d 767 11th Cir. 1995) Successful TM claim and profits were

awarded to P. Insurance company was required to

indemnify D for all profits awarded to P. Justification: Insurer knew terms of

Lanham Act when the policy was drafted.

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What Might not be Covered?

Computer network liabilityBreach of securityCrime and the InternetErrors and OmissionsIntellectual property infringement

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Suggested Minimum For an E-Commerce Site

LibelUnauthorized access (security)VirusesIntellectual property infringementWeb site failure - loss of dataProduct liability (if applicable)General liability (contractor is injured at

client site)

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Other Key Requirements

Negligent actsErrors and omissionsBreach of dutyGeographic scope of everywhere you

do business - including internationally. What could go wrong and how much

could it cost?

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Some Insurance is not Standardized

One size does not fit all - attorneys must be vigilant.

Every business has different needsIs the policy appropriate?

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General Liability Policies & I.P.

Commercial general liability (CGL) coverage policy (the most common): Advertising injury. “injury arising out of misappropriation of

advertising ideas or style of doing business,” or “infringement of copyright, title or slogan.”

Does this include online activities?

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General Liability (cont’d)

Few cases address the limits of advertising injury: P.J. Noyes v. American Motorists Ins. Co

(855 F. Supp. 492 D. N.H. 1994).

• Insured used P’s TM in its own advertising.• Insurer had a duty to defend and provide

coverage for claim of:– Common law TM and unfair competition.– False designation of origin and

misrepresentation.

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Not all I.P. Claims are CoveredAmerican Economy Ins. Co. v. Reboans, Inc. (852 F.

Supp. 875 N.D. Cal. 1994). (minority opinion!)

Insured was sued for selling counterfeit products.• Fed TM infringement, Fed counterfeiting, false representations

and designations of origin. Court said misappropriation was not covered and a TM

is not an advertising idea or style of doing business - copied products, not ads.

No reasonable expectation of coverage.

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Business Owner’s Liability Coverage

Advertising injury: “infringement of trademark, service mark, or trade name…in connection with goods, products, or services sold, offered for sale, or advertised by the insured.”

Parameter Drive Software Inc. v. Mass. Bay Ins. Co (25 F. 3d 336 6th Cir 1994): false designation of origin and unfair

competition are included in advertising injury.

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Reorganization / Bankruptcy

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Reorganizations

Important to recognize when to things are bad

IRC 368 October 18, 2000

In Stable Condition

The latest earnings reports carry more weight for the Internet Economy than any that have come before. The markets are in disarray, and deep currents of uncertainty run through once-confident companies.

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Introduction to Bankruptcy

Federal law (11 USC 101) designed to give debtors a ‘fresh start.’ Article 1 section 8 clause 4 of the constitution

gives Congress the authority to establish bankruptcy law.

Designed to fairly balance the interests of the overwhelmed debtor and the creditor(s).

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Key Forms of Bankruptcy

Chapter 7: complete liquidation of assets and discharge of (almost) all debts.

Chapter 11: reorganization to extend and / or reduce debt.

Chapter 13: provides 36-60 months for repayment of secured debts (and a percentage of unsecured debts). Not available for corporations. Must have a regular income.

http://www.scu.edu/law/FacWebPage/Neustadter/article9/main/commentary/15.html

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Most Failing e-Business Don’t Have Many Creditors

40 dot-coms went out of business in December, 2000.

Total cost to investors: >$1,500,000,000.Only ten filed for bankruptcy.The rest paid their bills and closed their doors.

No bank loans. Few assets.

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After the Funding is Gone, What Remains?

Intellectual property: Trademarks; Domain names; Patented processes; or Trade secrets.

Customer lists (be careful about privacy issues).

Net operating loss.Lease & equipment.Liquidity if shares are public.

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Risks to 3rd Parties

No payment for products or services.Cancelled executory contracts

Scramble for alternative suppliers.

No more product support or updates.Projects may be left incomplete.Assets or obligations tied up in bankruptcy

proceedings.

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Practical HintsEnsure the company’s cash burn rate is monitored

and understood.Use independent accounting / auditing services.Do a D&B or other search to assess the viability of

a third party before starting a business relationship.

Consider the possibility of bankruptcy in any contract.

Secure the assets in a transaction when appropriate (Article 9).

Contemplate an exit strategy when the business is first formed – not when it is failing.

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Questions & Answers

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Entity HandoutType of Entity

Liability Protection

Tax Number of owners

Type of owners

Good for VCs?

Tax free exit?

Distribution of property taxable?

C Corp Y X 2 Yes Yes YesS Corp Y X 1 <100 yes No Yes YesLLC Y X 1 No No NoLimited Partnership

Y/N X 1 No No No

General Partnership

No X 1 No No No