We sat down with David Sorin, Partner, Chair – Venture Capital & Emerging Growth Companies at McCarter & English for the first episode of the Entrepreneur’s Toolkit Series, presented by Edison Partners.
Edison Partners invests in and brings strong domain expertise to three areas: FinTech, Healthcare IT and Enterprise Solutions. Edison’s active portfolio has created aggregate market value exceeding $10 billion. Its long- tenured team based in Princeton, NJ manages more than $1 billion in assets throughout the eastern United States.
There are many legal facets of a company and it’s vital that CEOs understand them early in their company’s journey: should you set your company up as an LLC or corporation, the ins and outs of capital formation, the tax implications, and so much more. Keep reading to learn more!
Our Legal Expert: David Sorin, Partner & Chair – VC & Emerging Growth, McCarter & English
McCarter & English delivers innovative solutions to clients nationwide. Fortune 100, mid-market and emerging growth companies rely on McCarter to handle their cutting-edge transactional, intellectual property, and complex litigation advice. Dave’s vast experience with his startup and growth company clients makes him the perfect person to share key steps and advice that can set a startup up for success, as well as the common mistakes to avoid.
TechUnited CEO, Aaron Price, immediately jumped into one of the more prevalent issues that entrepreneurs face in the early stages of forming a business: what legal structure is best.
“Almost invariably, the decision is to do a C Corp, probably Delaware, for any company that is likely to pursue outside capital. Delaware C Corp, in general, is the form of the enterprise preferred by institutional investors, certainly venture investors, and even for those companies that might decide to form an LLC and convert later.”
Dave went on to discuss the other option, and the significant tax benefit of forming as a C Corp from the inception of a company as long as they qualify under the qualified small business stock tax exclusion. This tax benefit allows the owners of common or preferred stock of a C Corp that is a qualified small business to have an exclusion for federal income tax on the gain of sale of stock, as long as the owner has held the stock for five or more years.
If you’re not sure about raising capital, Dave shared that, “…there are two paths to take. One is starting as a C-Corp anyway if you might otherwise be eligible for the QSBS. Again, you don’t get that holding period stored until you own the C Corp stock. So if you start with an LLC and convert later, any time spent holding the LLC unit or membership interest won’t count towards the five year holding period.“
Aaron took a step back here to touch on the differences between these two structures and S- Corp structure.
In terms of an S-Corp, C-Corp and LLC, the benefit of all three structures is the owners have limited liability. They are not liable, generally speaking, for the obligations of the business. This gives them an opportunity to protect their personal assets from the obligations of the business.
LLCs and S-Corps are considered to be “tax pass through entities”. The entities are not taxable persons in their own right, whatever items of income and loss will flow through the enterprise to the owners, who will then have those items of income or loss on their personal tax returns.
By contrast, a C-Corp is a separate taxable entity. And so if it has income, it will be taxable in the corporate rates. If it has losses, those losses can be carried over for finite amounts of time into the future to offset future income.
Sorin shared the key reason loss plays a role in your formation decision: “your structure can make a very big difference in the early times when most companies are operating at a loss. Some owners believe that they will benefit and some in fact do benefit from having those tax losses available to them personally to offset other forms of income, and that’s when you are weighing, whatever that benefit is against whatever the risk is not meeting the five year holding period. “
Early stage companies and entrepreneurs have to consider more than just the tax implications of the structure of their organization. What about early employees and co-founders?
“One of the things that you hear often among founders in those kumbaya moments is equality. You know, let’s just share the equity, equally, because we’re all in this together. And while equality is sometimes the right answer. I have found that it is rarely the right answer.”
The harsh truth, often revealed too late for startup founding teams, is that founders bring different skill sets, different levels of commitment, different levels of importance to the achievement of the goals of the organization. One of the very first things that has to happen when forming a company is an honest, open discussion among co-founders, regarding equity allocation.
But what happens if somebody leaves?
The gist: it’s a risk of forfeiture and a repurchase option for the company. If you don’t have an ability to get back the unvested portion owned by the individual leaving, the remaining founders are going to suffer, and there will be added dilution if there is not a mechanism to get the unvested portion back.
In the absence of the founders imposing an investing schedule on their own, it is almost guaranteed that venture investors will impose one.
With the understanding of the implications around equity allocation and investing schedule, Aaron pressed on what are some of the other legal implications typically seen during first fundraising.
McCarter & English knows that one of the major points of concern is how has the company protected the intellectual property and confidential information of the company. “It is vitally important that the chain of title to that intellectual property and that confidential information be clear and protected. You want an unbroken chain.”
Another point of concern: Section 83(b) elections. This applies to equity that is subject to vesting.
83(b) election alerts the Internal Revenue Service (IRS) to tax the elector for the ownership at the time of granting, rather than at the time of stock vesting.
This means that you pre-pay your tax liability on a low valuation, assuming the equity value increases in the following years. However, if the value of the company instead declines consistently and continuously, this tax strategy would ultimately mean that you overpaid in taxes by prepaying on higher equity valuation.
Aaron: “I’ve had entrepreneurs ask me if I would sign an NDA before even looking at a business plan or pitch deck. This is an audience thinking about venture capital. What would you say about this?”
Dave: “Most venture capitalists will not sign an NDA. They are in the business of seeing hundreds, if not thousands of opportunities a year. They don’t want to have contractual obligations that might put them in a position of inadvertently violating someone’s rights because they looked at a pitch deck.”
And what about privacy policies and terms & conditions?
These are an effective part of a “starter kit” of documents that companies need to protect themselves and ensure customers know what the agreement is, and a critical part of building your infrastructure.
Is it ok to be a little scrappy or is it a recipe for disaster?
“Beware. Scrappiness is important. But there are risks associated with that.”
Partner with the right people; legal, accounting, finance. The right people who understand the market have programs in place. McCarter & English certainly does.
Step 1: Work with experts.
Step 2: Go with experts who also provide some kind of compelling value proposition
Step 3: Chemistry. Make sure you are working with someone you are comfortable asking questions. No question is naive, especially for first time founders.
Thank you again to Edison Partners and Alex Symos, Vice President of the firm’s Go-To-Market Center of Excellence for their partnership on this series!
Learn more about McCarter & English’s Venture Capital & Emerging Growth Companies team and what they do.