By Sasha Bau, Esq.
Turning a great idea into a successful startup is a task that requires not only the skills, business bravado and ample patience, but also sufficient funding and proper structuring. In this article we are providing a general overview of the legal aspects of forming and running a startup. Although the below review is not intended to replace advice of an attorney, accountant or a tax advisor, it should serve as a roadmap to the business set up process.

Before starting – evaluate your ideasAs a young and enthusiastic entrepreneur with a strong belief in your business model, you are probably eager to start your business without delay. Nevertheless, it is crucial to stop and think about your business concept. Before diving in head first, you should ask yourself: how good and marketable is your idea? What is your market need? What is your competition? Can you offer something no one else has? Once you have the answers to the above questions and before pressing forward, you should take care of the legal aspects of your future startup.

Keep your business separate

While you may treat your startup as your first born, legally speaking, your business and its operations must be separate and distinct from you. Forming a legal entity to operate your business is a crucial and necessary step in turning an idea into an actual startup business. As a practical matter, this crucial step tends to demonstrate its benefits and true value during times that business faces a negative situation, such as claims by creditors, a lawsuit or bankruptcy. In such instances, the primary advantage of operating a business through a legal entity is the limitation on personal liability that the business owners have in connection with the corporate liabilities of the business.

Of course, any business owner must be careful not to create a situation where such business owner’s use of business accounts and the business itself ‘merges’ with one’s person, so as to actually eliminate any legal separation between the two. In such instances, the courts may erase the limited liability of owners of the legal entity and impose upon them the liabilities of the legal entity.

In addition to the limited liability associated with operating a business through a legal entity, another important advantage is that raising capital for your startup is made easier by the sale of interests in the legal entity to the investors. In such manner, you can sell interests in your limited liability company to various investors and, as a result, the investors would be able to enjoy the profits of the startup once it “takes off”.

Choose the right legal entity

Choosing a legal entity to operate your business involves a multitude of considerations, including accounting, investment structure, tax aspects, employee incentives and estate planning. All of these considerations should be carefully evaluated with an attorney and an accountant of your choice to ensure that your interests are adequately protected. While there are different types of legal entities, the two most common forms of doing business are a limited liability company (LLC) and a corporation.

The charms of an LLC

Limited liability company structure offers a flexible form of doing business, which blends certain elements of partnership and corporation. Members of a limited liability company enjoy the limited liability mentioned above, and are governed by statutory provisions and by contracts the members enter into with respect to the affairs of the LLC. A further advantage of the LLC is the benefit of what is called “pass-through taxation.” The gist of it is that the LLC itself does not pay the tax on the income it received, but rather passes it through to the members of the LLC, who then report each member’s respective portion of the LLC’s income on individual tax returns. As there are no shares to be issued, the membership interests are held in percentages.

The rights and obligations associated with such membership interests are, by and large, set in the governing documents of the LLC, e.g. the operating agreement. The operating agreement is one of the key governing documents of any LLC, as it provides for the rights and obligations of all members. While simple operating agreements will refer to many statutory provisions and may be relatively short, complex operating agreements involving various tax, accounting and other considerations can be quiet long and costly to negotiate.

Although negotiating the provisions of a complex operating agreement in connection with your startup may seem like a daunting task, it is nonetheless a worthwhile investment. On the business side of affairs, the negotiation stages of the operating agreement often function as a process of crystallizing your business model and cementing the rules of business engagement with your partners or investors. On the legal side of affairs, a well drafted operating agreement sets forth the manner in which the profits are shared, delineates the issues relating to holding rights to LLC’s property, and establishes members’ rights and obligations.

On the way to become a corporate giant

While the flexibility of LLC and the relative simplicity of the initial set up provide many startups with any easy “start”, some startups may choose corporate structure. A corporation is a legal entity that is incorporated in a particular state and is authorized to issue shares to its shareholders. If shares are issued, the corporation is governed by its shareholders, either directly or indirectly. Most commonly, the board of directors that consists of either shareholders themselves, or shareholders’ appointees, makes all major decisions for the corporation with the best interests of the individual shareholders in mind. Generally, corporations do not offer the benefits of the pass through taxation and the rights and obligations associated with holdings shares are set by statute, by shareholders agreement, or the bylaws.

While there is a difference of opinion with respect to which structure better fits the startup model, corporation or an LLC, this theoretical debate is usually decided by the specific requirements of each startup. With that in mind, corporations, unlike LLC’s, are generally considered to be less flexible in their structure, in part, because the corporation may only issue a certain number of shares to its shareholders and does not offer the benefits of pass-through taxation.

However, operating your business through a corporation does offer certain benefits. If going public is in the stars for your startup, then corporation is the ideal way to go.  In fact, it would be exceedingly difficult to do an initial public offering through an LLC for a variety of reasons. It should be noted, however, that an LLC may be converted into a corporation should the need arise. In addition, corporate structure lends itself best to providing incentive stock options and similar arrangements with the startup’s employees.

Raising Capital

To make your startup happen you are going to need funding from investors. During the first stages of the startup you will need what is commonly known as the ‘seed capital’ to develop the prototype of your product. The follow on investment will have to come at a later stage in business development, which will be used to finance business operations.

Seed funding is normally obtained from various individuals or organizations who themselves are engaged in the technology business and are looking for new opportunities to invest in. At the seed stage, the investors, or “angels” are, for the most part, aware of the risks associated with the startup being in its beginning stages and therefore do not expect, by and large, to be presented with a detailed business plan, budget projections, market analyses and the like. Obviously, the more researched and thorough the startup appears, the better chances there are to convince an angel to provide seed funding.

Once you receive the seed financing and prepare the prototype of the product, you will be able to approach other sources of financing, such as venture capital and institutional investors. To launch a successful business pitch you will have to work hard, not only on your product, but also on its presentation. The investors will want to know where your product’s place in the market is, what your manufacturing/production capacity is, how do you stack up against your competition, and what are your budget projections going forward.

However, you must keep in mind that just because you received a big chunk of change for your startup to get up and running, you should be frugal in your budget. Getting seed or VC funding does not mean your startup becomes rich, however, getting big revenues may. One of the key reasons why many startups fail is because they run out of funding early on. While getting funding from angels maybe as easy as receiving a check, obtaining VC and institutional financing can take a long time. This is because institutional investors and VC’s take their time to evaluate your startup and its business projections. Good financial planning will ensure that you do not run out money before any VC back you up.

Keep your and other’s secrets 

Protection of intellectual property is paramount to any business. For startups, intellectual property is often the very element that defines its success or its failure. Thus, each startup must establish and implement an intellectual property strategy and protocol, which will ensure that its IP is adequately protected, owned and utilized.

First, don’t forget that you and other members of your startup have prior work experience and are likely to have executed various non-disclosure and non-competition agreements with other businesses. Before consummating the startup, make sure to inquire with your partners and workers about their employment and IP history so that your startup does not run afoul of any prior existing obligations.

Second, make sure that all IP created or acquired by the startup belongs to the legal entity operating it and that all confidential materials are kept secret. All of startup workers, vendors and third party contractors must execute appropriate non-disclosure and work for hire agreements, which should be drafted by an attorney. All of IP acquired by your startup must be documented through proper assignment agreements and other relevant documents.

Third, get proper licenses to use third party’s IP. Today’s technology development is often dependant on platforms that already exist and have been developed by third parties. Without properly obtaining permission to use such content, you are risking infringement lawsuits from the owners of third party content.

Fourth, do not disclose the nature or the purposes of your IP publicly, before deciding on the correct strategy. Often times, new startups will herald their arrival on the market by publicly promoting their product or service. However, before doing that you should use an attorney to determine what type of IP protection is available for your startup. Thus, for example, public disclosure of a patentable invention before filing patent application with the United States Patents and Trademarks Office may have disastrous consequences on obtaining patents rights. Disclosing other confidential IP information may result in loss of trade secrets.

Fifth, diversify your IP protection and think globally. IP protection comes in different forms and shapes that sometimes may overlap one over the other, and include trademarks, patents, copyrights, trade secrets, and rights of publicity. Consult an attorney to identify each type and make sure to obtain the maximum protection allowed under the law. You need to remember that IP protection is territorial in nature and if you operate in foreign markets, then you should explore IP protection with local counsel.

Sixth, keep up and maintain your IP protection. Many forms of intellectual property, e.g. trademarks, require proper monitoring and follow up. Failure to properly maintain and prosecute infringers of your IP may have adverse affects on the IP protection down the road.

Finally, keep in mind that low cost approach to IP protection may significantly hinder your IP rights. Instead of just trying to lower the costs, while keeping your mind on the overall budget, focus on the value of IP that may provide your startup with the highest returns. This is where you’ll need to spend most of your budget for IP protection. Remember that your IP may be the very reason why many VCs will choose to invest in your startup.

Instincts are great, but use your judgment – retain an attorney

Business instincts are probably going to drive your startup to the stars, but your business judgment will always tell you to hire an attorney to advise you on corporate, financing, intellectual property and other matters. Collaboration with the right professionals will end up being an investment worth taking.

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