Starting a Business

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 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.

As such, the LLC can be used for some multi-member startups and offers the advantage of informality in management. If this suits your team, and if none of the impediments described in the next paragraph apply, then by all means use the LLC format.

That said, the partnership-style structure does not lend itself well to common features of a startup. It is a clumsy vehicle for restricted stock (described below) 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, of course, cases where an LLC does make sense for a startup (e.g., where special tax allocations make sense, where a profits-only interest is important, where tax pass-through adds value, where a simple management structure is important and no special impediment to the use of the LLC applies).

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 to 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 adminstrative 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 a special prize for your early-stage startup. (For more on this topic, see What are the advantages and disadvantages of setting up a startup business in Delaware?)

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.

Note that use of restricted stock can raise tricky issues. What if a founder has already done something of great value for the startup? Should that founder's interest be put at risk of forfeiture? What if a founder is arbitrarily terminated? What protections exist for such situations?

The short answer to such questions is that restricted stock is very flexible.

Founders can set up their companies with a mix-and-match approach. With any given group of founders, some stock can be subject to forfeiture while other stock is not. Any given founder can have only a portion of that founder's stock be made subject to forfeiture while the rest is not. Acceleration provisions can be added to founder agreements to protect against arbitrary terminations. And vesting provisions can be mixed and matched as desired, with any length or rate of vesting used as appropriate to tailor the situation to the founders' deal.

It goes without saying, of course, that restricted stock is not for everyone, even for a founding team. Sometimes founders will find it inappropriate or will have enough trust in one another not to be concerned about anyone walking away. In such cases, plain, old unrestricted grants can be used (in such cases, though, VCs will later insist on vesting if they are brought in).

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 hanging 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.

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.

This post focuses on the forming of a Wholly Foreign Owned Entity (WFOE) in China. I am starting with this type of entity because it is the one we do most often. Subsequent posts will detail the steps required to register other forms of entities in China, such as a representative office (RO) or a contractual or equity joint venture (JV). Each of these forms of foreign invested enterprise (FIE) is subject to its own specific laws and to numerous regulations that apply to all FIEs. Every FIE is formed as a Chinese limited liability company (LLC).

Where the special laws and regulations of an FIE do not apply, the provisions of the Chinese Company Law control. The Company Law was recently completely rewritten to conform more closely to international standards for company formation and management.

The steps for forming a WFOE in China typically consist of the following:

1. Determine if the proposed WFOE will conduct a business approved for foreign investment by the Chinese government. For example, until recently, China prohibited private entities from engaging in export trade. All export trade was handled through certain large, state owned trading companies.

China recently abandoned this system, and now both foreign and domestic companies can set up trading companies.  Restrictions on export oriented trading companies have essentially been eliminated, but there are still controls on import oriented trading companies that can increase expense and raise costs. Because these rules were only recently changed, the local regulators who must approve these projects do not have a great deal of experience with the attendant issues. This can lead to some delay in the approval process. It also results in an extremely cautious approach towards adequate capitalization even for export oriented trading  companies. I discuss capitalization requirements in greater detail below.

2. Determine if the foreign investor is an approved investor. Basically, any legally formed foreign business entity is authorized to invest in a WFOE in China. China especially welcomes investment that promotes the export of Chinese manufactured products. The investor must provide the documentation from its home country proving it is a duly formed and validly existing corporation, along with evidence showing the person from the investor who is authorized to execute documents on behalf of the investor. The investor also must provide documentation demonstrating its capital adequacy in its country of incorporation.

To meet these requirements, the following documents are normally needed from the investing business entity:

a. Articles of Incorporation or equivalent (copy)

b. Business license, both national and local (if any) (copies)

c. Certificate of Status (Original)(U.S. and Canada) or a notarized copy    of the Corporate Register for the investor or similar document  (original)(Civil Law jurisdictions)

d. Bank Letter attesting to sound banking relationship and account status of the company (original).

e. Description of the investor's business activities, together with added materials such as an annual report, brochures, website, etc.

a-d are translated into Chinese. e is either translated into Chinese or summarized in Chinese.

Many investors created special purpose companies to serve as the investor in China . The Chinese regulators have become accustomed to this process. However, the Chinese regulators will still seek to trace the ownership of the foreign investor back to a viable, operating business enterprise. Investor secrecy is not an option in China. However, the corporate register for the Chinese company will merely state the name of the foreign, special entity investing company as the owner. In that sense, as far as public disclosure is concerned, the investor privacy can be maintained. The foreign investor should also understand that this tracing process will add some time and cost to the Chinese company formation process.

3. Chinese government approval for the project. In China, unlike in most countries with which Western companies tend to be familiar, approval of the project by the relevant government authority is an integral part of the incorporation process. If the project is not approved, no incorporation is permitted. The two are inextricably linked.

The following documents must be prepared for incorporation/project approval:

a. Articles of Association. This document will set out all of the details of management and capitalization of the company. Nothing can be left for future determination; all basic company and project issues must be determined in advance and incorporated in the Articles. This includes directors, local management, local address, special rules on scope of authority of local managers, company address, and registered capital.

b. Feasibility Study. The project will not be approved unless the local authorities are convinced it is feasible. This usually requires a basic first year business plan and budget. We typically use the client produced business plan and budget to draft up the feasibility study (in Chinese) that will satisfy the requirements of the Chinese approval authority.

c. Leases: An agreement for all required leases must be provided. This includes office space lease and warehouse/factory space lease.   It is customary in China to pay rent one year in advance and this must be taken into account in planning a budget because the governmental authorities will be expecting this.

d. Proposed personnel salary and benefit budget. If the specific people who will work for the company have not yet been identified, one must specify the positions and proposed salaries/benefit package. Benefits for employees in China typically range from 32% to 42% of the employee base salary, depending on the location of the business. Foreign employers are held to a strict standard in paying these benefit amounts. The required initial investment includes an amount sufficient to pay salaries for a reasonable period of time during the start up phase of the Chinese company.

e. Any other documentation required for the specific business proposed. The more complex the project, the more documentation that will be required.

All of the above documents must be prepared in Chinese.

4. It usually takes two to five months for governmental approval, depending on the location of the project and its size and scope. Large cities like Shanghai tend to be slower than smaller cities. The investor must pay various incorporation fees, which fees vary depending on the location, the amount of registered capital and any special licenses required for the specific project. Typically, these fees equal a little over 1% of the initial capital.

On large and/or complex projects, the approval process often involves extensive negotiations with various regulatory authorities whose approval is required. For example, a large factory may have serious land use or environmental issues. Thus, the time frame for approval of incorporation is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.

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