Ask the Attorney: Should I be a C-Corp? (And other formation issues)

(Editor’s note: “Ask the Attorney” is a VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)

Question:  Two former classmates and I are launching a new venture.  Unfortunately, we don’t have enough money to hire a lawyer.  I found a lot of articles on the web, but I’m still not sure what kind of entity we should form and where.  I also was wondering if there are any other legal issues we should be worrying about.

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Answer: Thanks for your questions.  Before I answer them, however, let me just say that I think it would be prudent for you to retain a good, reasonably-priced attorney to assist you and watch your back.  If you don’t have the money, some lawyers will defer their fees and/or take equity (if you can get them excited about your venture).

There are, in fact, many issues that should be on your radar – more than we have time to get into in a single column. In the interest of time and space, I’ll examine five this week and five next Monday.

1.  Choice of Entity.  What’s most important is you form an entity that will protect against personal liability.  You have three good choices: a C corporation, an S corporation or a limited liability company.  If you’re going to seek funding, you should form a C corporation because that’s the structure that investors will usually require.  If you’re not going to seek funding (or funding will not be imminent), you may want to form an S corporation or a limited liability company to obtain “pass-through” tax treatment.  The bottom line is that every situation is different, and that’s why it makes sense to sit down with a good lawyer.

2.  Place of Formation.  If you’re going to seek funding, you should form your entity in Delaware regardless of whether the operations are located in California (or any other State).  Why?  Because investors will usually require it due to Delaware’s well-developed case law, its management protections and flexibility, and its ease of corporate filings and related state-law administrative issues.  If the entity has not been formed in Delaware, investors will generally require this issue to be cleaned-up as a condition to closing.  Thus, initially forming in Delaware will demonstrate a certain level of sophistication and credibility.

3.  Equity Issues.  Form the venture and issue equity to the founders as soon as possible — i.e., before the company has any significant value.  Clearly, as the company meets milestones (e.g., the creation of a prototype, the signing-up of customers, etc.), its value – and that of the stock – will increase. This could trigger significant taxable income to founders being issued equity for services or for a nominal purchase price.  The same principle applies with respect to the issuance of options to employees: The goal is to do it as soon as possible – when the value of the company is as low as possible.

4.  Vesting Restrictions.  There are two good reasons to impose reasonable vesting restrictions (e.g., 25 percent/year for four years) on equity issued to founders.  First, it makes good business sense because the equity will presumably be issued not only for the founders’ services or property relating to the conception of the venture, but also for their continuing commitment and efforts.  Second, if you will be seeking funding, investors will usually require a vesting schedule.

5.  Issues re: Prior Employment.  Before you get too deep, each founder needs to review the agreements and documents with his or her prior employer. These could be offer letters/employment agreements, non-disclosure and inventions assignment agreements, stock options agreements, employee handbooks or any number of things. The point is: You need to determine if there are any provisions that may prohibit or create problems for the new venture.

Things to look for include (i) confidentiality provisions, (ii) non-compete provisions (which are generally unenforceable in California), (iii) provisions regarding the non-solicitation of customers, vendors or employees and (iv) provisions regarding the assignment of inventions.  If the new venture is a technology company, pay particular attention to the creation of the intellectual property and applicable law.

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