Startup Legal AdviceWhen you’re forming a startup, coming up with an idea is the easy part. What you’ve got to watch out for are the legal hoops you have to jump through to become incorporated as an official company.

While it’s difficult to travel along the legal road without any guidance, we here at Intelligent.ly were lucky enough on Monday night to have some help from a seasoned pro, Mick Bain. Mick is partner-in-charge at the Waltham office of WilmerHale, a world class law firm that has helped countless startups find their bearings, and one of Intelligent.ly’s awesome sponsors. Mick gave us the rundown on how to avoid the legal landmines when starting up. Read on to find out more.

Issues of Equity

Equity is perhaps one of the most dodgy subjects for an early-stage company. In terms of shares, a company can authorize as many or as little as they would like–meaning as little as 100 to as many as 1 billion. What only matters is the number of shares issued. This means that if there are 1 million shares authorized in a company, but only 500,000 have been issued among the founders, and the CEO holds 250,000 shares, she owns 50% of the company.

When incorporating as a legal entity and deciding who owns what, it’s important not to divide shares completely evenly among founders. While this may sound counterintuitive, and it is always good to build consensus among the team, not everyone will be contributing an equal amount to the project, and it’s important that there is one lead decision maker in times of disagreement.

Protecting Intellectual Property

Startup Legal Advice
Mick Bain

If you work for a company other than your own, chances are that you signed an agreement at the beginning of your employment stating that any idea you come up with while employed by the company will be owned by them. This can open up some pretty dicey legal battles if a company were to actually pursue a case.

Make sure to check your contract with your employer. Most of the time, the contract will state that if you come up with an idea on your own time and only use your own property (physical location, computers, other equipment) then you own the idea, but it’s best to double check.To avoid this issue all together, you can have the company sign an intellectual property waiver, effectively releasing any ownership they may have been able to claim over to you.

If you’re a technology company, beware of using open source software and code. While under the nature of open source, anyone can freely use it, there may be issues when using it to create a product that a company will sell. Check the license of the code–most will not have any restrictions on them, but some could potentially state that anything built using the software or code must be made available for free. If this is the case, you have no choice in whether or not you can sell the product for money.

Choosing a Legal Entity

Perhaps one of the most important decisions when starting a company is choosing which legal entity to incorporate as. While there are many choices, to prevent personal liability, one should never incorporate as a sole proprietorship or a partnership. For the typical startup, this leaves them three options to incorporate under: LLC, an S-Corporation, or a C-Corporation. The main difference between these entities mainly lies in the ways the government taxes them.

An S-Corporation is a pass-through entity, meaning the taxes are passed on to the owners and employees, and revenues and expenditures are only taxed once. At the same time, only human beings can serve as shareholders, the maximum amount of shareholders within the company is only sixty-five, there is only one class of stock, and no non-resident aliens of the United States can become a shareholder.

A Limited Liability Company is also a pass-through entity, but without any of the restrictions of an S-Corporation. The downside is that every time a new employee is brought in, the owners must redo the agreement, and the more employees, the more expensive it becomes to file taxes. Instead of the government issuing W2s to every employee of an LLC, it treats the employees as partners and issues them K1 tax returns.

A C-Corporation is not a pass-through entity, meaning that all profits are taxed twice. The upside of this entity lies in the fact that it does not have any of the restrictions on an S-Corporation. Most technology, life-sciences, and green tech companies don’t care about pass-through status as during the development of their initial product, they don’t bring in any revenue. Beware, most VCs will only invest in C-Corporations.

Where should you incorporate? The answer is almost always Delaware. With some of the lowest corporate taxes and fees of almost any state and the robust corporate legal system, it’s almost a no-brainer.

Interested in learning more? Check out Mick’s slides on Slideshare by clicking here.