By Michael M. Membrado and Christopher J. Gulotta
New York Law Journal
Monday, September 18, 2000

NOTWITHSTANDING the recent decline in dot-com mania on Wall Street, few would dispute that the technology and Internet sectors will continue to be active and important. While private financial markets have become more discerning in providing technology start-ups with seed capital, innovative applications of technology and cutting-edge business methodologies continue to flourish. The excitement associated with entrepreneurial innovation remains as robust as ever.

This article is intended as a general primer for the first-time entrepreneur contemplating starting a new business; the particular focus is on issues unique to Internet-related ventures. We look at select legal and business issues and obstacles that first-time entrepreneurs confront in developing start-up technology companies.

Founders' Agreements

As soon as two or more individuals decide to develop a company based around an idea or unique methodology and before any additional steps are taken towards that end, individuals must come to terms among themselves regarding:

(i) the roles and goals they expect to maintain in the future;

(ii) the relative ownership and control of the company that they will respectively maintain and how these factors may change over time based on certain events; and

(iii) their relative rights to buy the others' shares and/or sell their own under certain conditions.

These issues should be specifically spelled out in the form of a Contribution and/or Shareholders' Agreement. Having such agreements in place from the point of inception will go far in reducing one of the most under-acknowledged but common causes of death for early-stage companies — shareholder dissension and unresolved disputes.

Incorporation Decisions

Entrepreneurs who believe they can turn their idea into a business will be well served, for several reasons, by forming their corporate entity as early as possible. From a personal liability standpoint, once the corporation is formed, the founder(s) can begin entering into agreements on behalf of it rather than personally. In this fashion, incorporation allows such individual(s) to avoid personal liability for the debts, obligations and liabilities of the corporation.

For tax purposes, incorporating early on allows founders to take advantage of the favorable long-term capital gains treatment. In addition, the more time a founder is able to put between the date on which he or she first acquired shares in the company and the date of the first round of financing, the less likely it is that the IRS will later determine that the founder's receipt of stock was a taxable event, and attribute the less favorable ordinary income tax rates to the value.

In instances where founders and third-party investors must receive their equity interests at the same time, there are methods of attributing differing values to the shares, such as issuing common stock to the founders and preferred shares having superior rights to the investors. Nevertheless, the prudent approach, and the one that leaves maximum flexibility in structuring future financings, is to incorporate and issue shares to the founders early on in the life of the start-up.

A detailed discussion of the various different types of business entities is beyond the scope of this article, but suffice it to say that most start-ups intending to seek outside financing will form either a Subchapter C or a Subchapter S corporation. The decision of which of these types of corporations will be best suited for the founders is driven principally by tax considerations. S corporations may be advantageous to the shareholders since they afford "pass through" treatment to shareholders for purposes of federal income tax. On the other hand, S corporations are not as attractive to investors since they only permit the issuance of one class of stock, and only individuals (other than non-resident aliens), estates and certain trusts are permitted to become shareholders.

A small business "C" corporation should always issue so-called "Section 1244" stock (S corporations do not qualify under Internal Revenue Code §1244) to the original purchasers of stock in the corporation. By doing so, the original investors in the company will be in a position to receive more favorable tax treatment in the unfortunate event that they suffer a loss when they sell their shares, or if the shares become a total write-off. Individual shareholders in Section 1244 companies may take up to $100,000 tax loss against their ordinary income in the year of their loss, as compared to the $3,000 annual limit that applies to unincorporated businesses.

Silicon Alley companies with ambitions of going public or attracting sophisticated investors will invariably choose between New York and Delaware as their state of incorporation. The 1997 amendments to the New York Business Corporation Law (BCL) went far in making New York a more attractive state in which to incorporate by bringing its laws more in line with those of Delaware, a traditional haven for non-closely held companies (e.g., the presumption of shareholder preemptive rights was eliminated in New York).

Nonetheless, many New York-based companies still choose to incorporate in Delaware based on certain advantages that continue to exist, including the fact that, under §630 of the BCL, the 10 largest shareholders of privately held companies are personally liable for the payment of wages and other monies due to employees. Delaware has no similar statute or statutory mandated personal exposure for principals.

Employee Issues

Initial-Round Financing

By far the most pressing and misunderstood issue confronted by first-time start-up entrepreneurs is the challenge of raising the initial round of seed capital. While many who are confronted with this challenge for the first time believe that a magic formula exists for securing early-stage capital, the harsh reality is that it is a unscientific, haphazard process driven in large part by good fortune. The good news, however, is that one can dramatically increase the odds of experiencing this good fortune by formulating a game plan for pursuing the process based on the way such deals actually occur.

Having an appropriate game plan for conducting an offering (which is lawyer-speak for raising capital) requires that one understand the distinction between the two basic ways that offerings are carried out. The distinction is between so-called "negotiated" deals, on the one hand, and "unit" deals on the other, and essentially stems from the size and type of audience one expects to solicit for investment. A determination to pursue one as opposed to the other should be the result of the founders taking objective inventory of the breadth and nature of their contacts, both directly and through their close professional advisors such as accountants, attorneys and financial consultants. The strategies used to pursue one would not be appropriate for the other.

As the term implies, negotiated deals are those that are negotiated with investors. They generally involve stock purchase transactions with only one, or perhaps as many as six or even eight, investor(s). Negotiated deals typically also involve relatively sophisticated, and many times professional, investors. It is because of the relative sophistication of the investors involved, and their resultant ability to take advantage of their bargaining leverage vis-ˆ-vis start-up company founders, that these kinds of deals are negotiated.

In those cases where professional investors are involved, including venture capitalists, such deals tend not only to be negotiated, but highly negotiated. It is generally only in these cases where the discussion involves such typically unfamiliar terms as pre- and post-money valuations, convertible participating preferred stock, liquidation preferences, redemption rights, full-ratchet vs. weighted-average anti-dilution provisions, retroactive vesting and tag-along/drag-along rights. It is also customary in these kinds of investment transactions for the investors to have conducted an extensive due diligence analysis of the company independent of any business summary presented to them.

Where it is expected, by virtue of the target investors identified, that a negotiated transaction is likely to be involved, and only "accredited investors" (a commonly misused statutorily defined term referring to investors qualified on the basis of certain objective financial criteria) are being solicited, entrepreneurs will benefit from knowing that "shopping" the deal need only involve a good business plan (and maybe only a good executive summary and PowerPoint presentation), not a private placement memorandum (PPM). Although some form of PPM may ultimately become part of the documentation involved in the transaction, it is generally a waste of both time and money, and in many cases counter-productive to garnering the attention of certain investors, to shop a deal on the basis of a fully-developed PPM, which would include the price and terms of the deal. Where deals involve very high-risk ventures, sophisticated investors have no interest in having important terms dictated to them.

If one expects only to pursue institutional venture capital, therefore, by all means forego any expense of developing a PPM before first obtaining one or more term sheets indicating that an investment is likely to follow.

Unit deals, in contrast, are stock purchase transactions which are constructed on the basis of a pre-packaged bundle of securities (sometimes all of one kind but often involving a combination of common or preferred stock together with common stock warrants) to market at a certain pre-established price. Such transactions, which are also commonly referred to as "book" deals, do require the development of a detailed PPM prior to initiating the process of marketing the deal.

The PPM, which is a document the contents of which are statutorily mandated in cases where non-accredited investors are involved (but always advisable to guard against potential disclosure-related liabilities), ordinarily includes sections describing the business itself, certain risk factors associated with the investment, and a detailed description of the price and terms of the deal and how it is being sold.

Unlike negotiated transactions, unit deals at the start-up level are generally entered into between the company and around eight or more (and sometimes a lot more) investors, who tend not to be institutional (professional) investors, but rather high net worth individuals who have an appetite for investing in high-risk/high-yield ventures. It is very rare in these kinds of transactions, moreover, that the participating investors do any meaningful degree of independent due diligence in connection with their investments.

The most important characteristic setting unit deals apart from negotiated transactions is the fact that unit transactions are almost invariably marketed on a take-it-or-leave-it basis. That is, the price and terms are set before the investment opportunity is ever even proposed, and investors either buy into the deal as presented or take a pass.

Because of this distinction, companies that are able to pursue these types of transactions because of the nature of their contacts will generally be able to obtain a more favorable valuation for their offering and avoid having to grant many of the rights and privileges typically required by professional and/or otherwise very experienced early-stage venture investors. The trade-off is that the preparation of a PPM requires that significant legal fees be incurred before any meaningful investment commitments have been made.

Depending on the nature and extent of the contacts that a company has, therefore, both directly and through its team of professional advisors, a determination should be made as to whether a negotiated deal or a unit deal makes the most sense, and appropriate steps should be taken towards that end.

Shift Risk When Possible

Many of the unique and emerging risks facing technology companies that cannot be shifted contractually to other parties can be shifted to insurance companies. In addition to the insurance coverage that traditional brick-and-mortar businesses require (e.g., general liability, errors and omissions, property and casualty, product liability, business interruption, employment practices, etc.), technology companies, given the nature of their business, the new and rapidly changing medium through which they conduct their business and the fact that they typically have investors sitting on the board of directors or advisory board, need broader coverage.

Insurance companies, like regulators, law makers and courts, are wrestling with how to deal with this new medium, without the benefit of historical track records or actuarial tables.

Coverage can be obtained for technology-specific risk areas such as "Internet" security and intellectual property abatement. Because the rates for such coverage vary as much as the scope of the policies, however, technology entrepreneurs (as usually required by their investors) need to carefully review their product, service, business methodology and the specific coverage of their insurance policy to ensure that it is the insurance company and not the business that bears this risk.

Conclusion

Success depends on much more than possessing a great and timely concept, technology or innovative application, supported by adequate initial funding and great strategic alliances. The markets are speaking loud and clear these days: over the next few years, many dot-coms will fail and be forced to sell off technology and/or personnel at a "hard" valuation.

Companies must anticipate and steer clear of the many obstacles they will inevitably encounter. Getting informed about these challenges and dealing with them proactively where possible is essential. In the current business climate, there are no rehearsals.

Footnotes

(1) See Robert F. Lawrence, "Know What Your 'Options' Really Are," New York Law Journal, June 19, 2000, at S7 (Silicon Alley Special Section).

Copyright © 2001 The Gulotta Law Group, PLLC