There's something in the air. While not yet at the 1990s level, capital raising efforts in the United States are garnering attention, particularly with the social media and other technology start-up boom.
While entrepreneurs finalize their business plans and prepare for investor pitches, their counsel should be attuned to numerous legal issues.
Conflicts of Interest - Who Do You Represent?
Seeking engagement from two or more founders in forming a business entity can cause complications. It will not always be feasible, or the founders' preference, for each founder to have separate representation and, in some cases, counsel may conclude that he or she cannot effectively represent each founder, especially in the event of unequal capital contributions or business roles.
When founders jointly engage counsel, which often will be the case, counsel cannot withhold information from any one founder. All founders should be copied on each email and other correspondence and apprised of any discussions or other developments. After forming the entity, counsel typically will enter into a new engagement letter with the entity, in which case counsel should make clear, whether through non-representation letters or otherwise, that he or she represents the entity - not the individual founders.
Entity Selection - What Type of Entity and How to Respect It.
Venture capital firms typically avoid investing in entities taxed as pass-through entities, such as limited liability companies (LLCs) and partnerships. Those venture capital firms that attract pension plan and endowment money, for example, often place in the funds' organizational documents limitations on generating "unrelated business taxable income" (or UBTI). Tax-exempt investors avoid UBTI because it triggers a special tax return filing and additional taxes these investors may not otherwise incur.
Many start-ups initially will not be seeking funds from venture capital firms and will not be planning to "go public" in the short term, focusing instead on raising money from friends and family and angel investors. In these instances, an LLC or partnership likely will be preferable.
LLCs and partnerships do not pay federal income taxes; tax liability flows through to their members or partners, as the case may be, who will reflect any income and losses/deductions on their individual tax returns. Although tax law permits C-corporations to carry forward certain losses/deductions to future profitable years, the owners of LLCs and partnerships must report, for example, entity-level losses as incurred in any tax year. Further, in the event the business seeks a buyer, an asset sale by the LLC or partnership results in only one level of federal income tax - at the entity owner level - and typically creates a better tax and liability situation for the buyer. The relative flexibility of structuring the LLC's income and losses and transactions on the back-end is a marked advantage for LLCs and partnerships. Additionally, if the entity requires subsequent rounds of capitalization from venture capital firms requiring a C-corporation, LLCs can undergo a statutory conversion to a corporation. The reverse is difficult - corporations taxed as C-corporations face many hurdles in converting to a different entity or changing their tax election without tax cost.
Once counsel has formed the entity, he or she should advise the founders as to basic corporate formalities. Entrepreneurs, especially those with little business operational experience, often do not appreciate the nuances of an entity's separate legal existence. To limit any veil piercing, founders should, for example, adequately capitalize the entity, create a separate bank account, and not commingle personal and business funds. Depending on the entity type and governance agreements, the founders and the governing body, if any, need to hold required meetings and take formal action when required.
Deal Terms - Have You Vetted Your Client's Deal Terms?
Before the founders approach potential investors with a term sheet, counsel should review it, or, preferably, draft it. Investors will be frustrated if the definitive investor documents (such as the limited liability company agreement, in the case of an LLC) differ substantially from the term sheet or how the founders initially discussed the deal. When there will be two or more classes of equity, for example, the distribution and allocation waterfall should be vetted by tax advisers to ensure proper treatment.
Securities Laws - Keeping Your Client Out of Jail.
Counsel should be familiar with, at a minimum, the registration requirements under federal and state securities law, the applicable exemptions from registration, including Regulation D under the Securities Act of 1933, as amended, and anti-fraud rules.
Counsel may recommend conducting the private offering under Regulation D, and, to the extent possible, encourage his or her client to seek money only from "accredited investors," that is, those investors who meet certain suitability requirements under Regulation D, such as net worth and income levels. If the founders must seek money from "unaccredited investors," the entity must make more extensive disclosures, necessitating, in most instances, a full private placement memorandum. In any event, counsel should prepare an investor suitability questionnaire to confirm each investor's "accredited investor" status and, as applicable, advise as to Regulation D's prohibition on general advertising and solicitation. This prohibition in effect requires a pre-existing and substantive relationship between the entity and each investor.
If Regulation D is not available, the offering may be exempt under §4(2) of the Securities Act, an uncertain standard primarily governed by case law, which generally requires investors to possess financial sophistication and access to material information. In limited circumstances, counsel may prefer the §4(2) exemption, such as when there is little risk of the offering not meeting the exemption and/or few investors.
Any disclosures, or lack of disclosures, made with respect to the business and the deal, whether oral or written, including financial projections, will be subject to the anti-fraud protections under §10(b) of the Securities Exchange Act of 1934, as amended, and corresponding Rule 10b-5, and any state anti-fraud rules. Here, founders must avoid material misstatements or omissions, including illegal "puffing," or risk facing civil and criminal liability.
To limit the founders' exposure, counsel should prepare appropriate risk factors and securities law legends and include them in the investor packet or, if a private placement memorandum is being prepared, in the memorandum. Counsel's form investor documents, such as the subscription agreement, should provide that the investor is relying only on the definitive investor documents in making the investment, and not any prior oral or written representations.
Intellectual Property - Who owns the IP?
Many start-ups, especially technology companies, face intellectual property hurdles. In some cases, the founders will have developed intellectual property related to the business, which will need to be assigned to the entity, and documented, as a capital contribution. After forming the entity, the entity's employees or consultants may develop intellectual property. Even though the entity may be sponsoring this intellectual property creation, the "inventor," that is, the employee or consultant, generally will own the intellectual property.
Accordingly, adequate provisions should be in place, such as in employment or consulting agreements, to assign this intellectual property to the entity. As appropriate, these agreements also should contain confidentiality restrictions with respect to the intellectual property and business.
Confidentiality - Have You Protected the Business Idea?
It will be appropriate in some cases to request that potential investors execute confidentiality agreements before disclosing the complete business concept and deal terms. Investors may balk at signing a legal document, necessitating confidentiality agreements that are short and simple, and adequate to the situation.
When separate confidentiality agreements are not entered into, the subscription agreement, or some other definitive investor document, should contain a confidentiality provision that restricts the investors' ability to discuss the terms of the deal.
Representing founders and start-ups in capitalizations can be eventful, and being up-to-speed with the core issues and latest industry deal terms will serve you well.