Law Archives - BOLLYWOOD SURKHIYAN

Advent of Foreign Law Firms in India

The opening of a legal firm by a Nigerian in Delhi has not only lawyers up in arms against the unauthorized practice but has also revived the decade-and-a-half-old debate over the more important question – should foreign lawyers be allowed entry into India?

It is often asserted that India has the potential to become one of the world’s great legal centers in the 21st century, alongside London and New York. It has innate advantages in its common law traditions and English language capability. But until very recently India had not recognized the role that advisory legal services have to play in attracting foreign investment and developing a broader-based services economy.

India being a signatory to the General Agreement on Trade in Services (GATS) which is an organ of the World Trade Organization (WTO) is under an obligation to open up the service sector to Member Nations.

“Services” would include any service in any sector except services supplied in the exercise of governmental authorities as defined in GATS. “A service supplied in the exercise of governmental authorities” is also defined to mean any service that is supplied neither on a commercial basis nor in competition with one or more service suppliers.

Legal profession is also taken to be one of the services which is included in GATS. With the liberalization and globalization policy followed in India, multinationals and foreign corporations are increasingly entering India. Foreign financial institutions and business concerns are also entering India in a fairly large number. Their business transactions in India are obviously governed by the Indian law and the foreign law firms (FLF’s) and foreign legal consultants (FLC’s) being not fully conversant with the Indian legislation require the assistance of lawyers enrolled and practicing in India. This has led to the idea of entry of foreign legal consultants and liberalization of legal practices in India in keeping with the guidelines evolved by the International Bar Association (IBA) and the GATS. If this idea is to be put into practice, the Advocates Act, 1961 which governs legal practice in India needs to be amended.

Legal “practice” is not defined in the Advocates Act but a reading of Sections 30 and 33 indicates that practice is limited to appearance before any court, tribunal or authority. It does not include legal advice, documentation, alternative methods of resolving disputes and such other services. Section 24 (i)(a) of the Act provides that a person shall be qualified to be admitted as an Advocate on the State Roll if he is a citizen of India provided that subject to this Act a national of any other country may be admitted as an Advocate on the State Roll if the citizens of India duly qualified are permitted to practice law in that other country.

Section 47 of the Act provides that where a country specified by the Central Govt. in this behalf by a notification in the Official Gazette prevents the citizens of India from practicing the profession of law subjects them to unfair discrimination in that country, no subject of any such country shall be entitled to practice that profession of law in India.

The basic principles set out by IBA on the question of validity of FLC’s are fairness, uniform and non-discriminatory treatment, clarity and transparency, professional responsibility, reality and flexibility. The guidelines laid down by the IBA are as follows:

“Legal consultant means a person qualified to practice law in a country (home country) and who desires to be licensed to practice law as a legal consultant without being examined by a body or an authority to regulate the legal profession in a country (host country) other than a home country, such a person has to apply to the host authority for a license by following the procedure for obtaining a license subject to the reasonable conditions imposed by the host authority on the issue of licenses. This license requires renewal. A legal consultant has to submit an undertaking alongwith his application not to accept, hold, transfer, deal with a client found or assigned unless the legal consultant does so in a manner authorized by the host authority to agree and abide by the code of ethics applicable to host jurisdiction besides to abide by all the rules and regulations of both the home and host jurisdiction.

It is open to the host authority to impose the requirement of reciprocity and to impose reasonable restrictions on the practice of FLC’s in the host country, that the FLC’s may not appear as an attorney or plead in any court or tribunal in the host country and the FLC’s may not prepare any documents or instruments whose preparation or performance of other services, is specifically reserved by the host authority for performance by its local members.

Many experts have given their views on entry of FLF’s and FLC’s in India pursuant to GATS. They are not opposed to the idea but it is suggested by them that some restrictions, adequate safeguards and qualifications should be provided for besides reciprocity.

The restrictions, if any, will have to be reasonable. Obtaining Indian law degree and practicing Indian law for a period to be stipulated for entry may be the only reasonable restrictions. Canadian model of University training, examination and articleship administered through a joint committee accreditation may be a viable solution. To follow the principle of non-discrimination, it may not be possible to impose any onerous restriction limiting the clientele, the nature of legal work, the fees to be marked, the form of fees (Rupees or foreign currency) etc. So far as reciprocity is concerned level playing field and uniform code of conduct will have to be worked out. Many western nations allow their lawyers to advertise whereas in India the lawyers are not allowed to do so. In California the FLF’s were only permitted to deal in laws not specific to California. Even in countries like Singapore, Hong-Kong and Japan the FLC’s are restricted to servicing only foreign firms. The treatment meted out to FLC’s and FLF’s in other countries and the rules, regulations made to govern their practice in the foreign country should be thoroughly scrutinized before allowing the entry in India.

Even if reciprocity were allowed, no Indian firm would go abroad to conduct legal business not because it has no talent, competency or efficiency but economically it would not be a viable proposition. The Indian lawyers have no resources to set up an establishment in a foreign country nor will the Indian Government render any assistance to them to promote their business in a foreign country. Even the large population of non-resident Indians would not desire to patronize the Indian lawyers even though they may be experts in their own field because the resident lawyers having full knowledge of the law of the country would be available to them at reasonable price because for the legal experts from India apart from the fees charged for the legal consultancy/service they may have to spend on their traveling expense also. The legal service by calling Indian experts would be very expensive for the non-resident Indians and they may not get full effective service since the Indian legal consultants may not be very conversant with the laws applicable there. It is only if any Indian party is concerned in a dispute and the question relates also to Indian law that Indian legal Consultant would be invited to a foreign country and not otherwise. Such occasions will be rare. The picture is different in case of foreign firms who do business across national borders, due to globalization. They demand foreign lawyers since they like to rely on the services of professionals in their own country who are already familiar with the firm’s business. If the foreign firms carrying on business in India require advice here on home country law, that can be made available to them by the Indian law firms or the Indian legal consultants. They can also prepare the legal documentation or provide the advisory service for corporate restructuring, mergers, acquisitions, intellectual property rights or financial instruments required by the foreign firms. These aspects will have to be seriously considered while considering the principle of reciprocity. Reciprocity should therefore be clearly defined and must be effective. It should be ensured that the rules and/or regulations laid down should be strictly complied with otherwise as is the experience, the rules remain on paper and what is practiced is totally different. The authorities either do not pay any heed to the violations or they overlook or ignore it as in the case of the Foreign law firms in India in the Enron deal, the permissions for such law firms to set up liaison offices came from the RBI which reports directly to the Finance Ministry. When these law firms violated the very conditions of being liaison offices the RBI overlooked or ignored it.

Some are of the view that instead of being perceived as a threat to lawyers, this should be seen as a move to raising standards within the profession but with reciprocal arrangements. The legal profession as it was practiced years before by the legal stalwarts did have a very high standard. However, today that standard of profession is nowhere to be seen or experienced. Legal profession has also become totally commercialized with no human or moral values. The standard has gone down considerably. However, the fees charged have tremendously increased, disproportionately to the service rendered to the clients. No effort is being made in any corner to set the wrong or malpractices which have crept in in the legal profession. On this background, what would be the “raised standards”? If at all the standards are raised, would the entire class of legal practitioners in India benefit or will it be only a small section of the legal practitioners who would be able to take advantage of the new situation? In that case, can this move be said to be in the interest of the legal practitioners? The situation so far as the FLC’s are concerned would be completely different since all the FLC’s who aspire to come to India will get equal treatment whereas the Indian legal practitioners would be deprived of equality in profession. Besides the FLC’s will have foreign clients and even though they are allowed to practice in India with a reasonable restriction of obtaining law degree in India, for some time definitely they will need Indian lawyers to get their work done. With the resources at their end and with the higher exchange rate in currency, they will be able to hire and retain young lawyers with substantial pay packages, though as compared to their fees in their country it would be much lower, with the result that good reputed Attorney’s/Solicitor’s Firms in India would lose their good hands and their work may suffer. Law Firms in U.S.A have funds equal to the annual budget of the State of Maharashtra. With such resources, in a short time, such FLF’s would do away with the existing law firms in India. On this background would our law firms withstand the competition and the quality of service, is an important question to be examined.

The U.S and some other advanced countries have large law firms operating on International scales which are primarily business organizations designed to promote commercial interest of their giant client corporations. The size, power, influence and economical standards of these large international law firms would definitely affect the legal system of our country adversely. We cannot match howsoever far we may stretch it, their size, power and most importantly economical standard. There is a limitation here on the number of partners in an Attorney’s/Solicitor’s firm. The number is restricted to 20 under the Partnership Act, which restriction is non-existent in a foreign law firm. To bring uniformity this limitation will have to be removed allowing for more partners, increasing of funding and manpower.

Moreover the FLF’s have “single window services” meaning services which not only include legal but also accountancy, management, financial and other advice to their clients. The multidisciplinary partnerships will cater to the needs of the clients in the above-mentioned different fields. Such partnerships may endanger the ethics of the legal profession as confidential information may be passed out within the partnership to the non-lawyer professionals. This would prejudicially affect not only the clients but also the lawyers since the independence of the lawyers would be compromised. Once the FLF’s and FLC’s are allowed entry into India the Bar Council of India will have to make rules and regulations also for such multidisciplinary partnerships or single window services. The multidisciplinary partnerships may look attractive but the crucial question is whether the quality of services and accountability of systems can be maintained? The code of ethics needs review to bring international legal practice under its purview.

The Foreign law firms may seek license for full and regular legal practice like that of Indian lawyers or they may come for a limited practice of consultancy for foreign partners on home country laws. Accordingly the rules and regulations will have to be framed to meet both these situations. The FLF’s who intend to come for regular legal practice may have to be subjected to immigration and citizenship laws. Those who seek limited practice may enter into partnerships with the home country law firms without any scrutiny from the organized legal profession. It is therefore necessary that a transparent, fair and accountable system be evolved to regulate and control the internationalization of legal practice.

With the globalization and liberalization policy not only foreign businessmen have come to India for investment but even the foreign goods and products such as agricultural products and other goods have entered the Indian market. The Indian goods and products have to face a tough competition with these foreign products which are cheaper though may not be better in quality. The result is that the Indian agriculturists and merchants are seriously prejudiced in their business. We also have the example of Enron which was in news where the Indian law was modified without probably realizing the adverse effect it would have on the electrical companies in the State. The agreements signed with Enron do not appear to be in the interest of the State or the Nation. However, such matters are thought of only later and not when the actual action is taken. With the present experience, it is felt that we should not be carried away with the idea of raising our standards or of being on par with the other developed countries where the guideline of reciprocity may be followed and the FLC’s and FLF’s would be allowed to enter the country. We have to be very alert and watchful and think well in advance to do away with any lacunas or loopholes in the rules and regulations that may be introduced to safeguard the interest of the lawyers in our country.

One more point which may need consideration is about the countries who would be interested in India. Would these countries be the members of the World Trade Organization or would even the non-member countries be allowed to enter India? If the entry is restricted to only the members of the WTO and if any non-member country desires to enter India, would the entry be denied merely on the ground that it is not the member of the WTO or whether the non-member would be allowed entry to show our fairness and equality of treatment? Thus many countries may be interested in coming to India due to the liberalization; globalization and privatization policy followed in India but the chances of the Indian firms going out of India to enter any foreign country would be remote. The principle of reciprocity may be introduced on paper but may not be effectively followed.

It may be mentioned here that the “Lawyer’s Collective” has filed a public interest litigation before the Mumbai High Court questioning the phrase “practice the profession of law” under section 29 of the Advocates Act. The respondents in their petition include some of the FLF’s which had set up their own liaison offices in India. It is needless to point out that all the above points may be discussed and examined in the above petition, the result of which is awaited.

The Indian legal profession has, in recent years, undergone a significant change, emerging as highly competitive and ready to move along with the ongoing wave of globalization. The interest of foreign law firms to open shop in India therefore is hardly surprising, since India offers a full range of legal services, of comparable quality, at literally a fraction of the price that would otherwise have to be paid. The rather conservative and if one may use the word, “protectionist” stand of the Bar Council of India on the matter has, however, prohibited foreign law firms from operating in India. A number of the more established ones, perhaps unable to resist the immense potential of the Indian legal markets, and in anticipation of the “globalization of legal services” under the aegis of the WTO, are slowly (and quite discreetly) establishing their presence in India, this in a considerable number of cases taking the form of their entering into associations with Indian firms, and in the process, literally operating in India indirectly, despite the prohibitions against the same. An issue that has therefore started to attract the attention of not simply Indian lawyers, but also law school grads, is the likely consequences of the entry of foreign firms in India. Shall this help an already growing Indian legal market, or shall it only mean a job loss for Indian law grads?

The fact remains that India is in the process of globalizing its economy. In the process, the legal market opening up to competition from the international legal market is rather inevitable. Instead of deliberating about the advantages and disadvantages of the legal markets being opened up to foreign firms, it is perhaps more sensible to accept that the entry of foreign firms in India is only a matter of time. However, this should not mean that their operations should nor be regulated, since otherwise they may just push out the Indian firms. For law school grads, their presence in India could well translate into an increasing range of job opportunities, apart from their presence in India significantly influencing the way in which the Indian legal market evolves in the 21st century.

Startup Law 101 Series – Distinctive Legal Aspects of Forming a Startup Business With a Founder Team

Introduction

A startup with a founding team requires a special kind of company formation that differs from that used by a conventional small business in several key ways. This article alerts founders to those differences so that they can avoid mistakes in doing their setup.

Attributes of a Typical Startup Business

A startup is a type of small business, of course, and its founders want to make substantial and long-term profits just as any small business does. Perhaps some of the empty “concept companies” of the bubble era did not ever intend to build for long-term value but that era is over. Today’s startups need to build value in a sustainable market or fail, just like any other business. Nonetheless, a startup that is anything other than a solo effort does differ strikingly from a conventional small business. Why? Not because the enterprise itself has any different goal other than that of building long-term and sustainable value but because of how its founders view their short-term goals in the venture.

Unlike a small business, a startup founding team will adopt a business model designed to afford the founders a near-term exit (typically 3-5 years) with an exceptionally high return to them if the venture is successful. The team will often want stock incentives that are generally forfeitable until earned as sweat equity. It will typically want to contribute little or no cash to the venture. It will often have valuable intangible IP that the team has developed in concept and likely will soon bring to the prototype stage. It frequently encounters tricky tax issues because the team members will often contribute services to the venture in order to earn their stock. It seeks to use equity incentives to compensate what is often a loose group of consultants or initial employees, who typically defer/skip salary. And it will seek outside funding to get things going, initially perhaps from “friends and family” but most often from angel investors and possibly VCs. The venture will then be make-or-break over the next few years with a comparatively near-term exit strategy always in view for the founding team as the hope of a successful outcome.

The blueprint here differs from that of a conventional small business, which is often established by its founders with substantial initial capital contributions, without emphasis on intellectual property rights, with their sights fixed primarily on making immediate operating profits, and with no expectation of any extraordinary return on investment in the short term.

Given these attributes, company formation for a startup differs significantly from that of a small business. A small business setup can often be simple. A startup setup is much more complex. This difference has legal implications affecting choice of entity as well as structural choices made in the setup.

Startups Generally Need a Corporate as Opposed to an LLC Setup

An LLC is a simple and low-maintenance vehicle for small business owners. It is great for those who want to run their business by consensus or under the direction of a managing member.

What happens to that simplicity when the LLC is adapted to the distinctive needs of a startup? When restricted units are issued to members with vesting-style provisions? When options to buy membership units are issued to employees? When a preferred class of membership units is defined and issued to investors? Of course, the simplicity is gone. In such cases, the LLC can do pretty much everything a corporation can do, but why strain to adapt a partnership-style legal format to goals for which the corporate format is already ideally suited? There is normally no reason to do so, and this is why the corporate format is usually best for most founding teams deploying their startup.

A couple of other clinkers inject themselves as well: with an LLC, you can’t get tax-advantaged treatment for options under current federal tax laws (i.e., nothing comparable to incentive stock options); in addition, VCs will not invest in LLCs owing to the adverse tax hit that results to their LP investors.

LLCs are sometimes used for startup ventures for special cases. Sometimes founders adopt a strategy of setting up in an LLC format to get the advantages of having a tax pass-through entity in situations where such tax treatment suits the needs of their investors. In other cases, a key investor in the venture will want special tax allocations that do not track the investors percentage ownership in the venture, which is attainable through an LLC but not through a corporation. Sometimes the venture will be well-capitalized at inception and a founder who is contributing valuable talents but no cash would get hit with a prohibitive tax on taking significant equity in the company — in such cases, the grant of a profits-only interest to such a founder will help solve the founder’s tax problem while giving that founder a rough equivalent of ownership via a continuing share of operating profits.

In spite of such exceptional cases, the corporate format is overwhelmingly favored for startups because it is robust, flexible, and well-suited to dealing with the special issues startups face. I turn to some of those issues now.

Restricted Stock Grants – Rare for Small Business – Are the Norm for Startups with Founding Teams

An unrestricted stock grant empowers the recipient of such stock to pay for it once and keep it forever, possibly subject to a buy-back right at fair market value. This is the norm for a small business; indeed, it is perhaps the major privilege one gets for being an entrepreneur. It may not be worth much in the end, but you definitely will own it!

Unrestricted grants can be problematic in a startup, however. If three founders (for example) form a startup and plan to make it successful through their personal efforts over a several-year period, any one of them who gets an unrestricted grant can simply walk off, keep his or her equity interest, and have the remaining founders effectively working hard for a success to which the departing founder will contribute little or nothing.

Note that a conventional small business usually does not face this risk with anywhere near the acuity of a startup. Co-owners in a conventional small business will often have made significant capital contributions to the business. They also will typically pay themselves salaries for “working the business.” Much of the value in such businesses may lie in the ability to draw current monies from it. Thus, the chance for a walk-away owner to get a windfall is much diminished; indeed, such an owner may well be severely prejudiced from not being on the inside of the business. Such a person will occupy the no-man’s land of an outside minority shareholder in a closely held corporation. The insiders will have use of his capital contribution and will be able to manipulate the profit distributions and other company affairs pretty much at will.

In a startup, the dynamic is different because the main contribution typically made by each founder consists of sweat equity. Founders need to earn their stock. If a founder gets a large piece of stock, walks away, and keeps it, that founder has gotten a windfall.

This risk is precisely what necessitates the use of so-called “restricted” stock for most startups. With restricted stock, the founders get their grants and own their stock but potentially can forfeit all or part of their equity interest unless they remain with the startup as service providers as their equity interest vests progressively over time.

The Risk of Forfeiture Is the Defining Element of Restricted Stock

The essence of restricted stock is that it can be repurchased at cost from a recipient if that person ceases to continue in a service relationship with the startup.

The repurchase right applies to x percent of a founder’s stock as of the date of grant, with x being a number negotiated among the founders. It can be 100 percent, if no part of that founder’s stock will be immediately vested, or 80 percent, if 20% will be immediately vested, or any other percentage, with the remaining percentage deemed immediately vested (i.e., not subject to a risk of forfeiture).

In a typical case, x equals 100 percent. Thereafter, as the founder continues to work for the company, this repurchase right lapses progressively over time. This means that the right applies to less and less of the founder’s stock as time passes and the stock progressively vests. Thus, a company may make a restricted stock grant to a founder with monthly pro rata vesting over a four-year period. This means that the company’s repurchase right applies initially to all the founder’s stock and thereafter lapses as to 1/48th of it with every month of continuing service by that founder. If the founder’s service should terminate, the company can exercise an option to buy back any of that founder’s unvested shares at cost, i.e., at the price paid for them by the founder.

“At cost” means just that. If you pay a tenth of a penny ($.001) for each of your restricted shares as a founder, and get one million shares, you pay $1,000. If you walk away from the startup immediately after making the purchase, the company will normally have the option to buy back your entire interest for that same $1,000. At the beginning, this may not matter much.

Now let us say that half of your shares are repurchased, say, two years down the line when the shares might be worth $1.00 each. At that time, upon termination of your service relationship with the company, the company can buy up to 500,000 shares from you, worth $500,000, for $500. In such a case, the repurchase at cost will result in a forfeiture of your interest.

This forfeiture risk is what distinguishes a restricted-stock buy-back from a buy-back at fair market value, the latter being most often used in the small business context.

Restricted Stock Can Be Mixed and Matched to Meet the Needs of a Startup

Restricted stock need not be done all-or-nothing with respect to founder grants.

If Founder A has developed the core IP while Founder B and Founder C are just joining the effort at the time the company is formed, different forms of restricted stock grants can be made to reflect the risk/reward calculations applying to each founder. Thus, Founder B might get a grant of x shares that vest ratably over a 48-month period (at 1/48th per month), meaning that the entire interest can be forfeited at inception and less-and-less so as the repurchase right of the company lapses progressively over time while Founder B performs services for the company. Likewise for Founder C, though if he is regarded as more valuable than Founder B, he might, say, have 20% of his grant immediately vested and have only the remainder subject to a risk of forfeiture. Founder A, having developed the core technology, might get a 100% unrestricted grant with no part of his stock subject to forfeiture — or perhaps a large percentage immediately vested with only the balance subject to forfeiture.

The point is that founders have great freedom to mix and match such grants to reflect varying situations among themselves and other key people within the company. Of course, whatever the founders may decide among themselves, later investors may and often do require that all founders have their vesting provisions wholly or partially reset as a condition to making their investment. Investors most definitely will not want to watch their investments go into a company that thereafter has key founders walking away with large pieces of unearned equity.

Restricted Stock Requires an 83(b) Election in Most Cases

In an example above, I spoke of a $500 stock interest being worth $500,000 two years into the vesting cycle of a founder, with two years left to go for the remainder. If a special tax election — known as an 83(b) election — is not properly filed by a recipient of restricted stock within 30 days of the date of his or her initial stock grant, highly adverse tax consequences can result to that recipient.

In the example just cited, without an 83(b) election in place, the founder would likely have to pay tax on nearly $500,000 of income as the remaining stock vests over the last two years of the cycle. With an 83(b) election in place, no tax of any kind would be due as a result of such vesting (of course, capital gains taxes would apply on sale).

Tax issues such as this can get complex and should be reviewed with a good business lawyer or CPA. The basic point is that, if an equity grant made in a startup context is subject to potential forfeiture (as restricted stock would be), 83(b) elections should be made in most cases to avoid tax problems to the recipients.

Restricted Stock Grants Are Complex and Do Not Lend Themselves to Legal Self-Help

Restricted stock grants are not simple and almost always need the help of a lawyer who is skilled in the startup business field.

With restricted stock, complex documentation is needed to deal with complex issues. This is why the LLC normally does not work well as a vehicle for startup businesses. The value of the LLC in the small business context lies in its simplicity. Entrepreneurs can often adapt it to their ends without a lot of fuss and without a lot of legal expense. But the LLC is ill-suited for use with restricted grants without a lot of custom drafting. If your startup is not going to impose forfeiture risks on founders or others, by all means consider using the LLC as a vehicle. If, however, forfeiture risks will be in play and hence restricted stock will be used (among other tools), there likely is no special benefit in using the LLC. In such cases, it is usually best to use a corporate format and a good business lawyer to assist in implementing the setup.

Startups Also Use Other Equity Incentives Besides Restricted Stock

Unlike a conventional small business, a typical business startup will want to offer other equity incentives to a broad range of people, not just to founders. For this purpose, an equity incentive plan is often adopted at inception and a certain number of shares reserved to it for future issuance by the board of directors.

Equity incentive plans usually authorize a board of directors to grant restricted stock, incentive stock options (ISOs), and non-qualified stock options (NQOs). Again, complex decisions need to be made and a qualified lawyer should be used in determining which incentives are best used for which recipients. In general, though, restricted stock is normally used for founders and very key people only; ISOs can be used for W-2 employees only; NQOs can be used for W-2 employees or for 1099 contractors. Lots of issues (including securities law issues) arise with equity incentives — don’t try to handle them without proper guidance.

Make Sure to Capture the IP for the Company

All too many startups form their companies only after efforts have been well under way to develop some of the key IP. This is neither good nor bad – it is simply human nature. Founders don’t want to focus too much on structure until they know they have a potentially viable opportunity.

What happens in such cases is that a good number of individuals may hold rights in aspects of the intellectual property that should properly belong to the company. In any setup of a startup, it is normally imperative that such IP rights be captured for the benefit of the company.

Again, this is complex area, but an important one. Nothing is worse than having IP claims against the company pop up during the due diligence phase of a funding or an acquisition. IP issues need to be cleaned up properly at the beginning. Similarly, provision needs to be made to ensure that post-formation services for the company are structured so as to keep all IP rights in the company.

Don’t Forget the Tax Risks

Startups have very special tax considerations at inception owing to the way they typically are capitalized — that is, with potentially valuable IP rights being assigned, and only nominal cash being contributed, to the company by founders in exchange for large amounts of founders’ stock.

Tax complications may arise if the founders attempt to combine their stock grants of this type along with cash investments made by others.

Let’s assume that two people set up a company in which they each own 50% of the stock, and they make simultaneous contributions, one of not-yet-commercialized IP rights and the other of $250,000 cash. Because the IRS does not consider IP rights of this type to be “property” in a tax sense, it will treat the grant made to the founder contributing such rights as a grant made in exchange for services. In such a case, the grant itself becomes taxable and the only question is what value it has for determining the amount of taxable income earned by the founder as a result of the transaction.

In our example, the IRS could conceivably argue that, if an investor were willing to pay $250,000 for half of a company, then the company is worth $500,000. The founder who received half of that company in exchange for a “service” contribution would then realize taxable income of $250,000 (half the value of the company). Another argument might be that the IP rights really didn’t have value as yet, but in that case the company would still be worth $250,000 (the value of the cash contributed) and the founder assigning the IP rights would potentially be subject to tax on income of $125,000 (half the value of the company, owing to his receipt of half the stock).

There are various workarounds for this type of problem, the main one being that founders should not time their stock grants to coincide in time with significant cash contributions made by investors.

The point, though, is this: this again is a complex area and should be handled with the help of a qualified startup business lawyer. With a business startup, watch out for tax traps. They can come at you from surprising directions.

Conclusion

All in all then, a startup has very distinctive setup features – from forfeiture incentives to IP issues to tax traps. It typically differs significantly from a conventional small business in the way it is set up. The issues touched upon here illustrate some of the important differences. There are others as well. If you are a founder, don’t make the mistake of thinking you can use a do-it-yourself kit to handle this type of setup. Take care to get a good startup business lawyer and do the setup right.

Startup Law 101 Series – Ten Essential Legal Tips For Startups at Formation

Here are ten essential legal tips for startup founders.

1. Set up your legal structure early and use cheap stock to avoid tax problems.

No small venture wants to invest too heavily in legal infrastructure at an early stage. If you are a solo founder working out of the garage, save your dollars and focus on development.

If you are a team of founders, though, setting up a legal structure early is important.

First, if members of your team are developing IP, the lack of a structure means that every participant will have individual rights to the IP he develops. A key founder can guard against this by getting everyone to sign “work-for-hire” agreements assigning such rights to that founder, who in turn will assign them over to the corporation once formed. How many founding teams do this. Almost none. Get the entity in place to capture the IP for the company as it is being developed.

Second, how do you get a founding team together without a structure? You can, of course, but it is awkward and you wind up with having to make promises that must be taken on faith about what will or will not be given to members of the team. On the flip side, many a startup has been sued by a founder who claimed that he was promised much more than was granted to him when the company was finally formed. As a team, don’t set yourselves up for this kind of lawsuit. Set the structure early and get things in writing.

If you wait too long to set your structure up, you run into tax traps. Founders normally work for sweat equity and sweat equity is a taxable commodity. If you wait until your first funding event before setting up the structure, you give the IRS a measure by which to put a comparatively large number on the value of your sweat equity and you subject the founders to needless tax risks. Avoid this by setting up early and using cheap stock to position things for the founding team.

Finally, get a competent startup business lawyer to help with or at least review your proposed setup. Do this early on to help flush out problems before they become serious. For example, many founders will moonlight while holding on to full-time jobs through the early startup phase. This often poses no special problems. Sometimes it does, however, and especially if the IP being developed overlaps with IP held by an employer of the moonlighting founder. Use a lawyer to identify and address such problems early on. It is much more costly to sort them out later.

2. Normally, go with a corporation instead of an LLC.

The LLC is a magnificent modern legal invention with a wild popularity that stems from its having become, for sole-member entities (including husband-wife), the modern equivalent of the sole proprietorship with a limited liability cap on it.

When you move beyond sole member LLCs, however, you essentially have a partnership-style structure with a limited liability cap on it.

The partnership-style structure does not lend itself well to common features of a startup. It is a clumsy vehicle for restricted stock and for preferred stock. It does not support the use of incentive stock options. It cannot be used as an investment vehicle for VCs. There are special cases where an LLC makes sense for a startup but these are comparatively few in number (e.g., where special tax allocations make sense, where a profits-only interest is important, where tax pass-through adds value). Work with a lawyer to see if special case applies. If not, go with a corporation.

3. Be cautious about Delaware.

Delaware offers few, if any advantages, for an early-stage startup. The many praises sung for Delaware by business lawyers are justified for large, public companies. For startups, Delaware offers mostly administrative inconvenience.

Some Delaware advantages from the standpoint of an insider group: (1) you can have a sole director constitute the entire board of directors no matter how large and complex the corporate setup, giving a dominant founder a vehicle for keeping everything close the vest (if this is deemed desirable); (2) you can dispense with cumulative voting, giving leverage to insiders who want to keep minority shareholders from having board representation; (3) you can stagger the election of directors if desired.

Delaware also is an efficient state for doing corporate filings, as anyone who has been frustrated by the delays and screw-ups of certain other state agencies can attest.

On the down side — and this is major — Delaware permits preferred shareholders who control the majority of the company’s voting stock to sell or merge the company without requiring the consent of the common stock holders. This can easily lead to downstream founder “wipe outs” via liquidation preferences held by such controlling shareholders.

Also on the down side, early-stage startups incur administrative hassles and extra costs with a Delaware setup. They still have to pay taxes on income derived from their home states. They have to qualify their Delaware corporation as a “foreign corporation” in their home states and pay the extra franchise fees associated with that process. They get franchise tax bills in the tens of thousands of dollars and have to apply for relief under Delaware’s alternative valuation method. None of these items constitutes a crushing problem. Every one is an administrative hassle.

My advice from years of experience working with founders: keep it simple and skip Delaware unless there is some compelling reason to choose it; if there is a good reason, go with Delaware but don’t fool yourself into believing that you have gotten yourself special prize for your early-stage startup.

4. Use restricted stock for founders in most cases.

If a founder gets stock without strings on it, and then walks away from the company, that founder will get a windfall equity grant. There are special exceptions, but the rule for most founders should be to grant them restricted stock, i.e., stock that can be repurchased by the company at cost in the event the founder leaves the company. Restricted stock lies at the heart of the concept of sweat equity for founders. Use it to make sure founders earn their keep.

5. Make timely 83(b) elections.

When restricted stock grants are made, they should almost always be accompanied by 83(b) elections to prevent potentially horrific tax problems from arising downstream for the founders. This special tax election applies to cases where stock is owned but can be forfeited. It must be made within 30 days of the date of grant, signed by the stock recipient and spouse, and filed with the recipient’s tax return for that year.

6. Get technology assignments from everyone who helped develop IP.

When the startup is formed, stock grants should not be made just for cash contributions from founders but also for technology assignments, as applicable to any founder who worked on IP-related matters prior to formation. Don’t leave these hangning loose or allow stock to be issued to founders without capturing all IP rights for the company.

Founders sometimes think they can keep IP in their own hands and license it to the startup. This does not work. At least the company will not normally be fundable in such cases. Exceptions to this are rare.

The IP roundup should include not only founders but all consultants who worked on IP-related matters prior to company formation. Modern startups will sometimes use development companies in places like India to help speed product development prior to company formation. If such companies were paid for this work, and if they did it under work-for-hire contracts, then whoever had the contract with them can assign to the startup the rights already captured under the work-for-hire contracts. If no work-for-hire arrangements were in place, a stock, stock option, or warrant grant should be made, or other legal consideration paid, to the outside company in exchange for the IP rights it holds.

The same is true for every contractor or friend who helped with development locally. Small option grants will ensure that IP rights are rounded up from all relevant parties. These grants should be vested in whole or in part to ensure that proper consideration exists for the IP assignment made by the consultants.

7. Protect the IP going forward.

When the startup is formed, all employees and contractors who continue to work for it should sign confidentiality and invention assignment agreements or work-for-hire contracts as appropriate to ensure that all IP remains with the company.

Such persons should also be paid valid consideration for their efforts. If this is in the form of equity compensation, it should be accompanied by some form of cash compensation as well to avoid tax problems arising from the IRS placing a high value on the stock by using the reasonable value of services as a measure of its value. If cash is a problem, salaries may be deferred as appropriate until first funding.

8. Consider provisional patent filings.

Many startups have IP whose value will largely be lost or compromised once it is disclosed to the others. In such cases, see a good patent lawyer to determine a patent strategy for protecting such IP. If appropriate, file provisional patents. Do this before making key disclosures to investors, etc.

If early disclosures must be made, do this incrementally and only under the terms of non-disclosure agreements. In cases where investors refuse to sign an nda (e.g., with VC firms), don’t reveal your core confidential items until you have the provisional patents on file.

9. Set up equity incentives.

With any true startup, equity incentives are the fuel that keeps a team going. At formation, adopt an equity incentive plan. These plans will give the board of directors a range of incentives, unsually including restricted stock, incentive stock options (ISOs), and non-qualified options (NQOs).

Restricted stock is usually used for founders and very key people. ISOs are used for employees only. NQOs can be used with any employee, consultant, board member, advisory director, or other key person. Each of these tools has differing tax treatment. Use a good professional to advise you on this.

Of course, with all forms of stock and options, federal and state securities laws must be satisfied. Use a good lawyer to do this.

10. Fund the company incrementally.

Resourceful startups will use funding strategies by which they don’t necessarily go for large VC funding right out the gate. Of course, some of the very best startups have needed major VC funding at inception and have achieved tremendous success. Most, however, will get into trouble if they need massive capital infusions right up front and thereby find themselves with few options if such funding is not available or if it is available only on oppressive terms.

The best results for founders come when they have built significant value in the startup before needing to seek major funding. The dilutive hit is much less and they often get much better general terms for their funding.

Conclusion

These tips suggest important legal elements that founders should factor into their broader strategic planning.

As a founder, you should work closely with a good startup business lawyer to implement the steps correctly. Self-help has its place in small companies, but it almost invariably falls short when it comes to the complex setup issues associated with a startup. In this area, get a good startup business lawyer and do it right.