for the Start-Up Netpreneur
A Seminar On Fundamental Legal Issues
Q: When setting up a corporation, what's the
advantage to declaring no-par value for your stock, or going to par value of a fraction of
a percent or one percent?
Mr. Wilson: The states impose something
called franchise tax on corporations that helps fund their operations. Different states
calculate it different ways. The old trick used to be that they would calculate franchise
tax on the number of shares. People started having fewer shares and they started
calculating it on par value, so you got penny par because you could do 10 million shares
and pay a lower franchise tax. So, people thought, "We'll have no par stock and
eliminate the franchise tax altogether." Several states have responded to this,
including Delaware. There, you pay more for no-par than you do for penny par. As a result,
par value is almost irrelevant in your planning.
Q: For a very small start-up, if you start out
as an S corporation, then later your business expands, is there difficulty in upgrading it
to a standard corporation which might make it easier to go public? What are the tax
consequences of converting from an S to a C corporation?
Mr. Shaw: Basically, the year in which you
either revoke your election or otherwise cease to meet all the requirements of an S
corporation is bifurcated into two short taxable years. You are treated as an S
corporation for the short taxable year beginning January 1 and ending on the day before
the event that terminates your S corporation status. As of the day that you revoke or
cease to meet the requirementsfor example, if you have more than 75
shareholderson that day you are treated as a C corporation and taxed as a C
corporation for that part of the year forward.
Q: Are there any issues we should be aware of
in dealing with other people who feel that their copyright rights have been violated when
we link to their siteparticularly relative to frame technology, where you can have
your own site framing somebody else's?
Ms. Gallagher-Duff: There are several
issues involving trademarks as well as copyrights. There are several cases in the courts
dealing with framing issues as well as linking issues.
Q: When you are starting a company and issuing
equity to people who are working for you without getting paid, how do you set the value of
the stock when you are issuing options? How do you set the value of the stock when you are
negotiating for loans? Do those numbers get made up as you go?
Mr. Wilson: The answer is, with the
employees you make it up; with the lenders, you have to prove it.
Ms. Moore: And the IRS cares what number
you make up for the employees.
Mr. Wilson: It's worth what the company is
worth. I know that's a glib answer, but fundamentally it's correct. You can assign a value
you like; an interest in the company is worth a percentage of what the company is worth.
In terms of compensation, if you structure it correctly, you will prevent the employee
from being taxed on the initial grant, and then the issue becomes one of tax based on
appreciation. Up front, if you have a dollar par stock and you issue ten shares, you have
a $10 interest, if your investment is only the capital.
Mr. Voltmer: Before the company goes
public or before you enter into your first venture capital financing, the value can be set
with what you can negotiate with the bank, then with the employees. When you deal with a
venture capitalist, you are setting the value based upon the transaction involving that
particular third party.
Q: For each stock offeringfor employees
one, two, three and subsequentlywhat do you do with the venture capitalists? Are
those separate securities offerings? If so, how are they dealt with without getting into
Mr. Voltmer: With a good lawyer.
Mr. Wilson: Legal careers have been made
and lost on the question of whether an offering to one person should be integrated with an
offering to another. A great many of your tax dollars are hard at work over at the SEC
considering whether the law requires putting such offerings together. The bottom line is,
if you are reasonably well isolated in time and purposeincluding different types of
securitiesthey probably won't be put together. For those who are somewhat aware of
what the issues are, if you start putting a lot of shares out to a lot of different
people, you suddenly will have the SEC interested. There are statutory exceptions for a
variety of different transactions, including employee offerings, but the short response to
your question is that you hope that they are each separate offerings.
Mr. Voltmer: It is a complicated issue and
it is one that you ought to keep in mind. Many of our start-up clients have to focus on
it. As a lawyer, you try to get involved, as much as you can, in business decisions that a
client is making, such as how is the client going to compensate employees, and focus on
federal and state exemptions to security registration requirements, the class of
securities the client is issuing and the timing for the issuance, as well.
Mr. Wilson: Let me hit on a separate issue
involving employee matters because it is an incredibly arcane area. There was a
medium-stage company, a typical guy who started in his garage with absolutely nothing.
Eventually, his business became an acquisition target and a beautiful one. At the time, he
had about five years in and 34 employees. We had a purchase price on the table of about
$52 million. This thing looked great. The acquirer, as is quite often the case with
reasonably aggressive high-tech companies, wanted to treat the acquisition as a pooling of
interestnot recognizing goodwill in the acquisition, but bringing it in as a merger
for accounting treatment. That technique was originally designed for mergers but is
increasingly being used in the acquisition context. Pooling gets spooked if you have
unissued employee options, other promises of issuing shares, or a changing share structure
that hasn't either been fully set up, fully vested or completely written and documented in
the 18 months before the transaction takes place. Of course, the difficulty is that you
always find yourself thinking three weeks ahead, not 18 months. This acquisition fell
through. It was 12 months before the guy found an offer for $30 million. For those of you
who have that in mind"Let me get it up and running, jump out. I don't want to
ride this thing. I'm in this business for the short term."be careful about how
you set up employee compensation and be sure that you get it finished well before you plan
to sell. Don't make promises to employees and then wait until a potential acquirer comes
along to complete your option scheme.
Q: Most of these deals that get put together
are not among employers and employees, but rather among "partners," for lack of
a better term. For example, a guy on the West Coast approached us with a technology. He
needed marketing and sales help and some other elements. There is a guy here who I have
just gotten to know recently. He and I have to form an agreement as to what we are going
to do. There are two other people in Annapolis who are bringing consent to the venture. We
have to bring them into it, and these people on the West Coast. How do we set this up? Is
this pretty bizarre?
Mr. Voltmer: Actually, it's pretty common.
Mr. Jack: Partnership or Shareholder
Agreements. What you have are different intellectual property assets, different know-how
from different people coming together and consolidating it into a business. Oftentimes, in
those types of situations, it will be like a joint venture where you will collectively put
together your business plan. Collectively, you will then decide who is going to contribute
what assets, what money. That will be spelled out in the business plan and an agreement
will wrap on top of that and commit the people.
Mr. Wilson: Yes, what you describe is a
partnership or LLC in which three separate entities are shareholders or interest holders.
You may have a partnership on the West Coast and maybe the guy here is a sole proprietor.
If you are in it together for the long haul, you may be focusing on the entity that's
common to each of you, the entity that's going to be held by all three. You may form a
partnership at that level and corporations or LLCs at the ownership level up top. The
first thing to do is get the shareholders set up. Figure out what each party in that deal
is going to do internally, then the three parties which result need to get together and
Mr. Voltmer: It will help if you can align
your business deal with the guy on the West Coast. It may not be a straight transfer of
that intellectual property into the new venture. If that's not the case, if he is granting
certain intellectual property rights, that could dictate the entity. Everybody has to have
a heart-to-heart talk with each other. What do you really expect of this? If you can
articulate that to the team up here, they could put the right vehicle in place.
Q: What about the opposite situation? If you
have a venture in mind, you are one person with some ideas, and you are contemplating
bringing other people into it. What comes first, the idea of bringing people in or the
Mr. Wilson: In our experience, almost
everyone waits too long. When I say "Follow the money," I mean that you must
decide when there are either revenues or multiple partners. If you have the foresight to
do it earlier, more power to you. If you set up an entity in advance of getting started,
there is great merit in that. You do want to be careful about getting ahead of yourself.
If you know precisely what each new entrant is going to bring to the table, then the form
of entity to choose can be planned in advance. If you don't know precisely what the
partners are going to bringtechnology, money, expertiseand if you don't have a
clear picture of who brings what and what they are going to get in return, it might be
Mr. Shaw: I would add some minor tax
points to that. With the advent of the "Check-The-Box" regulations that make
classification a little bit easier for tax purposes, a single member LLC is disregarded
for tax purposes. It's treated as if it didn't exist. That cuts down your tax planning
considerably and provides some state law protection as a limited liability company without
the concurrent tax complexities. Therefore, you haven't limited yourself on the tax side.
The other thing to take into account is that, if you are eventually going public and
cashing out or selling more than 20% of the business, get into a corporate form. Most
likely you want to do that relatively early to preserve the ability to go public in a
tax-efficient manner. The bottom line is that you need 80% control of a corporation in
order to make a tax-free contribution of property for stock. It's a technical rule for tax
purposes, and you want to be very careful about whether or not you can make that. Talk to
a tax advisor. If you are going public, you want to think about your tax status beforehand
and get into the right entity as soon as possible.
Q: I have heard that there are increasingly
sophisticated models for how to value intellectual property. What models have you
encountered in various stages of development of a corporation, especially in terms of
Mr. Wilson: The issue is in the investment
banking community. Intellectual property alone has not traditionally been regarded as
being worth very much. This, of course, is changing. A lot of environments in which you
are working are reasonably new and were not susceptible to the analytic models that
existed for manufacturing business. Your general impression that there is development in
that market is absolutely correct. I'm not familiar, myself, with any particular models
that are gaining acceptance, other than DCF, which most people regard as the best
approach. Economic value-added, a DCF variant, is getting a lot of consideration. How do
you make the valuations? I'm not familiar with a specific model that is getting more or
less attention, and I spend a good deal of my career arguing about how you ought to value
intellectual property. The range of approaches is still vast.
Q: There is a lot of talk about whether you
should incorporate in Delaware or Virginia. Are there certain states which offer benefits
to founders in terms of transferring the assets of the corporation, whether by a sale or
IPO? What about being a foreign corporation in Maryland and having to file in two
Mr. Wilson: I don't know if there is any
particular difference in the state law about the transfer of assets that would dictate a
particular choice. The primary difference in corporation law among the states is the ease
of administration and the clarity of existing rules. Each state is slightly different, but
the bottom line is that most of the areas that you are concerned about are as follows:
What does the board of directors have to do? What are the fiduciary duties imposed on the
board? What rights do shareholders have? What kind of change of control provisions are
there under state law? Delaware and New York are big, big corporate states. In both cases,
there is a lot of case law making these issues much more clear. Most public companies are
Delaware incorporated because there is a great deal of relevant jurisprudence. The
investment community is quite comfortable with the Delaware statute. Not to say that there
aren't some Virginia public companies; there certainly are. Its an individual
decision in each case. You can change your residency of incorporation reasonably easily.
There are migration provisions in a lot of states, so if you are in Virginia now, and you
are not sure where you are going to go, you don't want to pay Delaware and Virginia.
Assuming there is nothing particular in your business plan or capital organization that
doesn't work in Virginia, you can incorporate there, and if you need to go to Delaware,
you could do that.
Mr. Shaw: You also want to take into
account where your investors or members or owners are locatedtheir states of
residencebecause that may have an impact on state tax issues. For example, one thing
I mentioned was that the District of Columbia doesn't recognize S corporations as a
flow-through entity. If you have persons who are living outside of the District of
Columbia, you might not want to start an S corporation in DC because you may wind up
paying entity level taxes which you might not in another jurisdiction.
Mr. Jack: Virtually any corporate lawyer
anywhere in America is pretty comfortable with Delaware corporation statutes and can
incorporate a Delaware corporation. Not every corporate lawyer in America is familiar with
the Nevada corporation statutes. You have greater choice of lawyers if you are in
Q: Are there any industry studies which can
serve as a guideline to a company that has a range of employees and contractors and is
wondering what is "normal" among high-tech companies for providing incentives,
such as incentive stock options and stock options in general?
Ms. Moore: There are many such studies.
One unfortunate aspect is that they tend to focus on public companies because their market
is shareholders who have been presented a proposal to issue another 100 million options to
the CEO and want to know whether they are out of the ballpark. There are many compensation
consulting firms who are in the business of benchmarking, of telling their clients how
their proposed compensation arrangements compare with those of other entities. Such
studies probably exist, but, if not, they are certainly something you can commission.
Mr. Wilson: Hunt through Edgar, the SEC
Web site. Pick any public company that you know to be a competitor in your area and read
the registration statement or anything about employee compensation. It has to be
described, at least in general terms. You will get an idea, and, at least, will find out
what companies are paying who are looking to pick up your employees.
Ms. Moore: There are also institutional
shareholder watchdog organizations in the business of keeping an eye on what public
companies are doing. They provide information to shareholders about where stock
compensation trends are headed and whether their company is headed in the wrong direction.
There is a lot of information about public companies in various places, less on
closely-held companies, but it's probably available, if you look for it.
Mr. Voltmer: The June 1, 1998 issue of
Forbes has an article on CEO compensations at http://forbes.com/tool/toolbox/ceo.
Q: We have a software consulting company that's
an S corporation and has developed some Internet products. We really want to capitalize on
those with venture capitalists to develop them, but we don't want to capitalize the
consulting firms that we are thinking about spinning-off and creating another corporation.
What are the issues we should be considering in moving that intellectual property?
Mr. Shaw: Starting with the tax issues,
whenever you are transferring appreciated property outside of a corporation, which
presumably this is, you have to be very careful to make sure that you come within a very
specific non-recognition provision. Otherwise, a transfer of the appreciated property out
of an S corporation will trigger the tax, at least on one level. You also have to make
sure that you dot your Is and cross your Ts for qualifying for a
non-recognition transaction, either a reorganization of the company or a proper
contribution to a new entity, etc.
Mr. Wilson: If the intellectual property
you are talking about will still be used at all in the course of the consulting business
at the S corporation level, and if the ownership of that S corporation and the ownership
of new company are at all different, you have arm's length issues about the relationship
between the two companies. What right does the S corporation have to make use of
intellectual property? If you put it in a different place, as long as everybody on both
companies is identical in their percentage ownership and each company is identical, the
issue doesn't matter too much. That never lasts very long. Uncle Fred and Aunt Mabel each
owned 50% and three generations later, all the heirs are suing each other because somebody
didn't have the right number of children and it messed up the ownership interests.
Q: When we develop a program for a client, we
produce source code that makes the computer do certain things. The client is buying the
things that the computer is doing, what it is projecting on to the screens, etc. Where
does the source code ownership lie? The client wants a piece of it.
Mr. Voltmer: Depends on your development
agreement with the client. The ownership issue is going to be wrestled with in the
Mr. Wilson: You'll have an argument about
work for hire, if it isn't clearly established, but by and large, I would assume in that
case, you are likely on the losing end of that battle
Mr. Berman: I don't know which end you are
on. I'm Paul Berman. I'm a partner here at Covington & Burling. We worry about those
kinds of issues. For most of the people setting up businesses here, the problem is that
when a consulting firm shows up and says"I'm going to draft and write computer
code for you, I'll install the object code on your machine, but I'm going to keep access
to the source code."by and large, in those situations, it's the person who
writes the code that starts out being the author, unless (1) there is either an express
agreement that transfers ownership or (2) the person writing the code is an employee doing
it as part of his or her employment. Your situation is a hybrid of that, but these are the
things that in all of your agreementswhether you are a purchaser of code or a
commissioner of codeyou ought to look at. Make sure that you nail down in your
agreements the issue as to the transfer of the software. Everybody is talking about the
software as if it were an asset that you can actually transfer. You have to be very
careful about this. Take care of those things at the outset,
please. We have seen lots of deals foundered because we couldn't figure out who owned what
and who had the right of transfer. Take care of them early. It's easy to do early. It's
really hard to do later.
Q: It belongs to the originator of that source
code up to the point where there is agreement?
Mr. Berman: United States Copyright Code
provides that, in the absence of the agreement, the originator of the code is the owner.
You need to take care of that with your employees as well.
Mr. Voltmer: I try to get start-up
companies to focus on these issues in terms of value issues and the transactional cost
involved in resolving them, if they are not addressed properly. If you don't have these
issues buttoned down very, very clearly for the person who is going to invest in your
companythe investment bankerit will be reflected in the valuation of the
company and the price that the investment banker is willing to pay. There is going to be a
discount in your companys valuation because of the uncertainty as to the ownership
of intellectual property and the transactional costs in resolving the issue. We have all
been involved in situations like thisup at 2:00 in the morning and paying off that
one programmer to go away and solve that one outstanding intellectual property issue. It's
the wise person who focus on these issues ahead of time and gets them buttoned down. It
will save you a lot of time and money in the future.
Mr. Berman: It involves employees, too.
The employee is doing the writing in the course of the business. Save yourself
aggravation. Get your employees to sign a copyright and patent and invention assignment
agreement. Just take care of all that early, and then you won't have an argument with your
employee who shows up nine years later and says, "I really wrote that on my own
computer on my own time." It has happened.
Q: As a content producer, often larger
companies want some period of exclusivity on the content. After that period, exclusivity
lapses and they will have nonexclusive use as will you. Who owns the copyright? They will
put a seal on it. Can you put it on as well?
Mr. Wilson: Unless you have assigned the
copyright, you continue to own it. If you give them a license, even on an exclusive basis,
you still own it. They ought to be saying, "copyright you" on their display. You
shouldn't be saying, "copyright them." Make sure the copyright notice is
absolutely valid, but it's your copyright. They are the only ones who can display it, but
it's your copyright unless you explicitly assign it.
Mr. Voltmer: Thank you very much for
attending, and please let us know if we can be of further assistance. And thanks to the
Netpreneur Program and the Morino Institute for allowing Covington & Burling to put
this evening together.
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