Business start-up

WPresentation of chicken entrepreneurs and founders Parsons Elevator When it comes to raising capital for their business, I often find that they fail to take the basic steps to properly set up the business. Missing these early stages will result in additional time and expense, as we work to pitch the business to financiers or strategic partners. Below are some basic precautions and basic steps to facilitate a better capital raising process.

Form the body

An important first step is to actually create an entity. This creates protection from personal liability for the entrepreneur’s business. It also creates a framework for conducting business. Initially, the decision to form a business as a corporation or limited liability company (LLC) is made based on tax planning and other business goals, including the desired physical management structure. It may change form later as the business evolves and its needs and requirements change.

If outside funding is required early in the process, it may be more appropriate to set up the business as a corporation, as this is a more common and frequent vehicle for foreign investors. Also, investors often shy away from ‘pass-through’ entities for tax purposes. Forming a corporation allows early shareholders to benefit from qualified small business stock treatment, if applicable. Alternatively, forming a business as an LLC allows for flexibility and customization in terms of negotiations between the owners, as well as avoiding double taxation at the corporate and owner levels.

Regardless of the type of legal entity, founders must ensure that they use the appropriate formation and management documents. For a corporation, this includes articles of incorporation, bylaws, and usually a shareholder agreement. For an LLC, the operating agreement between the members includes important administrative and tax provisions. In Utah and many other states, it is extremely important for LLC members to form a comprehensive operating agreement, as the default rules under state LLC law are often unsolicited and do not reflect the desired business terms.

Take out the founder’s equity and plan the cap table

Founders must disclose their ownership rights and the consideration paid to receive equity in the company. At this stage, inventors must contribute intellectual property and business concepts to the enterprise, so that the enterprise owns the business concept. This can be documented through contribution agreements and creative allocation agreements and provides convenience to the investor who owns the company and allows for monitoring of the proposed business.

As part of the formation process, a founder must consider the equity structure of the business. How much equity is held by the founders? by workers? By third party investors? What securities should be allowed and what rights should go with the securities granted to investors? Part of this process requires the founder to accept that the founder faces dilution when other parties come into ownership. In a corporation, this can be partially resolved through a shareholders’ agreement that includes voting provisions that define the composition of the board and what type of vote is required for certain items of action. The agreement also details how the shares will ultimately be transferred and gives the company and other shareholders the right to remove shareholders who do not contribute to the company or do not perform as the parties have agreed.

Explain the equality of workers

Initially, a business must determine the equity provided by employees. Companies can use equity compensation as a way to reward employees, especially when they don’t have the earnings or cash to pay cash bonuses to their employees. A business offers equity to employees to align employee interests and provide incentives to increase company value. Employees should be given equality in connection with obtaining intellectual property rights and placing strict agreements on the employee for confidentiality and other restrictions to protect the company. Employee equity may be forfeited or revoked if the employee does not continue to work with the company or violates restrictive covenants.

The nature and type of equity incentives vary depending on the size and value of the company. First, restricted shares can be issued because this has less tax implications for the employee and results in direct ownership. Stock options are also possible at this stage or later stages. Stock options allow employees to lock in the purchase price for the stock at an upfront price.

To properly implement employee equity incentives, a company-wide reward plan should be implemented that gives the company flexibility in determining the terms and conditions of equity awards as the company grows and develops. It is important to present this to investors as part of the company’s growth plan.

Protect the intellectual property

A primary due diligence issue for investors is evaluating a business’s intellectual property (IP). Protecting IP rights should be a top priority for founders. A company must carefully document and verify IP creation and protection. Every employee involved in IP creation is required to perform IP duties to ensure that the company owns any IP created on behalf of or in connection with the company’s business. The Company shall require each contractor and third party involved with IP to execute appropriate assignment and ownership agreements. Even if the Contractor creates IP as a result of the Company’s direct involvement, the Contractor shall own any resulting IP unless the Contractor executes appropriate assignment and ownership agreements. As part of this process, employees and contractors must ensure that any IP created is not third-party and that any IP is self-generated.

When implementing an IP protection program, a software business must define policies that determine when open source code can be used and ensure that all licenses are properly followed. Investors and buyers are concerned that the company is not infringing these or other software licenses.

Sign the documents

It may seem obvious, but a business must ensure that carefully prepared documents and agreements are fully enforceable and kept in the company’s records. Unfortunately, it is not uncommon to find that a company is unable to execute the documents or is unable to access the properly assigned documents. In those cases, a company may find that its rights are unenforceable and its business is unprotected, reducing the company’s value.

Founders often find that consulting with legal counsel early in a company’s formation can save time and money—and avoid the stress of learning too late that the company is under-protected and unable to implement the next business steps.

About Shan El Hanna

Shane L. Hanna is a contract attorney at Parsons Elevator and a shareholder at Parsons Behle & Latimer with over 25 years of experience. Shane regularly assists clients in formation and corporate matters, corporate governance, debt and equity financing, securities matters, mergers and acquisitions, technology transactions and other matters. Learn more here.