October 1992
Difficult as it may seem, it is important before a new start-up is formed to make the best guess possible as to how the venture’s life cycle will unfold. Many important (and sometimes irrevocable) decisions depend on what route is chosen. This article will focus on a number of issues which require such decisions, particularly with reference to two typical corporate life cycles: a “bootstrap” approach and a venture-backed path.
Choice of Form. The first decision for a start-up is to choose a legal form: the typical choices are a partnership, a “C” corporation (a corporation which pays taxes) and an “S” corporation (profits for S corporations are taxed to the shareholders). For most ventures, the corporate form will be appropriate choice, since a properly maintained corporation should shield the founders’ personal assets from liability. A corporation is also the traditional choice where venture capital money is to be sought. Only in limited situations is a partnership appropriate.
Choosing S corporation status will often be the safest choice at the time of incorporation, particularly where the founders hope to sell the business after significant value has been created. When such a sale occurs the buyer will often refuse to buy the stock of the company. Rather, the buyer purchases only agreed-upon assets and assumes agreed-upon liabilities. In a stock sale, all assets and liabilities of the seller are assumed, whether the buyer wants them or not.
Unfortunately, the proceeds from an asset sale by a C corporation will first be taxed to the corporation; then, when the profits are distributed to the stockholders, the remaining proceeds are taxed once again. Although a portion of the price paid in such in an asset sale may often be paid in the form of non-competition or other types of payments that are not doubly taxed, there are limits to how much of the price can be allocated in that manner. An additional problem is that such payments cannot always be paid in proportion to stock ownership. In order to avoid these problems, it is essential for the venture to start life as an S corporation, since there is a ten year “look back” provision in the tax laws which applies to sales of assets by corporations which have changed their status. Under this provision, the appreciation in value of the assets from incorporation through the date on which the company converted from a C corporation to an S corporation (if less than 10 years) would be subject to double taxation.
Founder Agreements. Founders of a company should also carefully discuss among themselves the legal obligations which they should personally assume to insure the success of the venture. These include the contribution of pre-existing technology to the new company, and entering into non-disclosure and non-competition agreements. The rights and obligations of founders relating to voting and stock ownership are typically contained in a stockholder agreement. That agreement will often provide for the repurchase of a founder’s stock upon her leaving the company, in order to provide a means for the departing founder to cash in on her investment, and in order for the other founders to be sure that only active participants in the business will benefit from and control the company.
Venture capital investors will invariably insist on agreements which require employees to subject part or all of their stock to “vesting” (i.e., the right of the company to repurchase the shares of the employee for nominal value, with the number of shares which can be bought in this way declining over time). Where a company knows that it will seek venture capital funding the founders might as well enter into such agreements in advance, since in that way they may be able to control the exact wording of the agreements by which they are bound. However, if these agreements are too lax, or the vesting period which they include is too short, the founders should anticipate that their investors will require appropriate amendments.
Although topics such as non-competition, non-disclosure and vesting are often thought of as being necessary evils imposed by investors, it is worth noting that each founder is in fact an investor in her own venture. Seen from this perspective, each founder should be concerned with building and protecting the value of the enterprise, even at the cost of accepting the imposition of some restrictions on the founder. It also should be remembered that prudent, well-balanced decisions about such restrictions are much more easily made by co-founders when no one knows which founders will stay and which founders will leave as the company goes through various stages of growth.
Corporate Maintenance. Although no company should be casual about keeping good records and observing corporate formalities, it is essential that any start-up which wishes to seek venture capital or go public keep its corporate, stockholder record and contractual house in scrupulous order. It is equally important that a venture structure itself in as simple a fashion as possible, and avoid creating confusing and complex contracts and multiple layers of ownership.
Similarly, all start-ups should be aware that all sales of stock by the venture (and many loans to the company) are subject to complicated state as well as federal securities regulations. These should be carefully observed from the very first issuance’s to the founders, since unraveling snarls in this area is very frequently a costly, onerous and sometimes impossible task. Because cleaning up any messes of this type will be required before a venture capital financing or a public offering can be completed, it should be remembered that the company is usually least able to afford the delay and cost of correcting the situation at that time.
Financial Records. While a company which intends to remain closely held and avoid bank borrowing is free to select whatever level of accounting assistance it finds appropriate to its founders’ desires, a venture which seeks other peoples’ money will find that sophisticated investors typically insist on detailed financials kept in accordance with “generally accepted accounting principles”, usually from a well-recognized public accounting firm. The requirements imposed by the securities law with respect to companies which wish to go public are even more crucial and inflexible. The cost of creating accurate financial records for prior years in order to register a public offering can equal or exceed all other costs of the offering itself. More than one company has found it necessary to delay going public for years as a result of incomplete or non-standard financial record keeping in its early years. Accordingly, the time to begin keeping appropriate financial records is from the date of incorporation.
TLB Comment: This discussion has necessarily made many generalizations in order to cover complex considerations in overview fashion. Anyone forming a company should be sure to explore these concepts in greater detail, and in a manner tailored to their own situation and goals.