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Starting up a Tech Company

Advanced Technology Seminar

April 8, 2013

Todd Krieger and Cyrus Daftary

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Administrative discussion – papers, presentations, etc.

Business plans Forming an entity Insurance Bankruptcy

Agenda

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Business Planning

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Why Do We Cover Business Planning in a Law School Class?

Better serve clients/company by understanding the big picture: More opportunity to provide insight. Expand legal services for client.

More likely to notice potential legal pitfalls. Make sure client can pay. Law firms use business plans.

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Technology Start-up Companies Have Many Challenges

Market demands quick innovation Today’s technology idea is dated technology

in a year; Patents; Legal constraints can be a minefield; Technology licenses; and Regulatory and safety approval.

There may be more barriers to entry than a decade ago.

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The Competitive Environment Online Has Changed.

It is no longer adequate just to have a good idea. You need: A strategy/long term plan; Capital; Good management; Industry contacts . . . and a little luck.

A company can still thrive without offering revolutionary change. Not everyone has to be the next eBay.

http://www.youtube.com/watch?v=zhnEjxsjjuA

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Business Plans are Vital for a Company

A good business plan will provide a roadmap of development including: executive summary; core strategy defining product; identifying the market opportunity/niche; competition/threats; revenue and expense projections; sources of capital; short and long term plans; and management team.

E-Business Legal

Handbook Appendix A

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How are e-Business Plans Different?

Forecasts based on history.

Extensive, static plan.

Standard MBA format.

Concrete market research.

Forecasts are speculative.

Shorter, dynamic plan.

Whatever it takes to get funding.

Ambiguous market research.

Traditional B Plan Online B Plan

www.dotcomplans.com/compare.htm

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Client Example: Challenges Facing a Start-up (Part 1)

Good idea - not enough capitalization. Everyone wants a piece of the company in exchange

for work. Programmer will not prioritize project - spends two hours

instead of 20 committed hours. Attorneys offer to help, but are unavailable.

How do you create an incentive for people to work for a piece of the company while still maintaining control over the quality?

‘Will Work for Stock’

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Red Flags in a Business Plan Get rich quick plans

“Someone will want to acquire the business after we get it running.”

“We’ll devote time to this until the IPO and retire young.”

“We do not have time for market research - I have heard about this enough on TV. If we do not bring this idea to market soon, someone else will.”

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Red Flags in a Business Plan (cont’d)

Risks: All of the intellectual capital is in one person. Reliance on uncommitted resources (“my

cousin said he would host this for free” or “I can get a free billboard from a brother-in-law”).

Management has no experience.

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Client Example: Challenges Facing a Start-up (Part 2)

Client calls up with a vague idea and wants to schedule a meeting.

Client and colleagues spend hours developing a ‘mission statement’ instead of business plan. No idea of target market No plan to market services

Idea falls apart within a month, but legal bill is still paid!

The Dream Team

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Client Example: Challenges Facing a Start-up (Part 3)

Interesting idea but esoteric. One person’s idea, others have a cursory

understanding. Does the programmer cede his idea to his

corporation letting others enjoy the fruits of his labor?

What is left if the key programmer leaves?

One Founder’s Idea

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A Few Fundamental Questions Realism test:

How did you create your sales projections? What will you do if sales do not meet

projections? How is this different from the competition?

Infrastructure test: How will customers learn about your web

site/product? Who will maintain the site/fulfill the product

orders?

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Client Example: Challenges Facing a Start-up (Part 4)

Clever idea but not unique. Client wants legal documents ASAP.

Non-disclosure agreement. Incorporation documents. Contracts for:

Customers; Programmers; Employees; Content providers.

Problem: he has not even figured out his business plan. What does he really need?

Cart Before the Horse

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Client Example: Challenges Facing a Start-up (Part 5)

Clever idea. Client asks everyone’s opinion in an effort to get private investment.

Decides a confidentiality/non-disclosure agreement would be helpful.

Will friends/family sign non-disclosure agreements after the fact?

What if the idea is not unique and already in the public domain?

“Cat is out of the bag”

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Business Entity/Incorporation Planning for the future:

Succession planning - who will replace a programmer who leaves?

Partial dissolution - what if a partner wants to be bought out?

Future financing – is there planning for a transition from a sole proprietorship to a publicly-held corporation and what happens in between?

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Forming an Entity – Issues to Consider:

Taxation Liability shield Likely source of financing Number of owners Types of owners Types of distributions Likely exit scenario

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C Corporation Liability protection for owners Subject to double taxation – at entity level and

on distributions Distributions of property to owners are taxable No limit on number or type of owners Appealing to venture financing sources Some exit transactions can be structured in a

tax advantageous way (tax-free merger)

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S Corporation Liability protection for owners Subject to single level of taxation – no tax at entity level

but tax paid by shareholders Limit on number of owners (100) Limit on type of owners (individuals only, no foreign

persons) Many financing sources cannot participate (i.e., venture

capital funds) Some exit transactions can be structured in a tax

advantageous way (tax-free merger) Limited to one class of stock (other than non-voting

stock)

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LLC

Liability protection for owners Subject to single level of taxation – no tax at entity level, but tax

paid by owners (members) No limit on number of owners No limit on type of owners Unappealing to many financing sources – LLCs likely to

generate UBTI and be engaged in U.S. trade or business Generally no ability for tax-free exit transactions Distributions of property to owners are not taxable transactions Not as well received by the institutional investing community

Not normally used for venture-backed businesses Documents may cost more to prepare as they tend to be ‘non-

standard’

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Limited Partnership

Liability protection for some, but not all, owners (limited partners)

No liability protection for general partner Subject to single level of taxation – no tax at entity level, but tax

paid by owners (partners) No limit on number of owners No limit on type of owners Unappealing to many venture financing sources – likely to

generate UBTI and engaged in U.S. trade or business Generally no ability for tax free exit transactions Distributions of property to owners are not taxable transactions Not used in many contexts but common for private equity funds

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General Partnership

No liability protection for partners Subject to single level of taxation – no tax at entity

level, but tax paid by owners (partners) No limit on number of owners No limit on type of owners Unappealing to many venture financing sources –

likely to generate UBTI and engaged in U.S. trade or business

Generally no ability for tax free exit transactions Distributions of property to owners are not taxable

transactions Public filings are generally not required Not widely registered but common

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Every Entity Type Has Different Implications

Type of Entity

Liability Protection

Tax Number of Owners

Type of Owners

Attractive to VCs?

Tax Free Exit?

Distribution of Property Taxable?

C Corp Y X 2 Yes Yes Yes

S Corp Y X 1 <100 Limited No Yes Yes

LLC Y X 1 No No No

Limited Partnership

Y/N X 1 No No No

General Partnership

No X 1 No No No

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Initial Financing Look out for securities laws. Consider future financial needs and

revenue streams. What constraints will outside

investors place on new ideas or product development?

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Debt Financing Bank loans

Unlikely to be obtained unless company is already financed

Avoid personal guarantees Convertible Debt – best early stage financing

vehicle Promissory notes that convert into preferred stock,

once a financing occurs Avoids valuation problems Can be used in angel or friends and family financings Simple, low transaction costs, minimum negotiation

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Friends & Family

Limit number of investors Seek accredited investors only Structure (stock v. convertible debt) Valuation issues

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Angel Investors

Structure (avoid preferred stock) Try to avoid valuing the company Avoid onerous terms that might prevent a

venture capital financing

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Venture Capital

VC Requirements Strong management team Unique idea IP advantage Big market

Terms Preferred Stock (liquidation preference, dividends, anti-

dilution, etc.) Control (at board and stockholder levels; contractual

rights)

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Securities Law Considerations – Selling Unregistered Securities

General rule Number of investors Type of investors (accredited v. non-accredited) No general solicitation or advertising Consequences of violations

Rescission rights Could prevent or delay future financings

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Insurance for eCommerce

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Insurance for On-line Activities You do not have to be an expert on

insurance law to counsel a client doing business online - just know the potential risks.

Understand the basic elements of the policy and look for potential exclusions that might hurt your client.

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Insurance can Protect a Client against Bankrupting Claims

Limelight Productions, Inc. v. Limelite Studios, Inc. (60 F. 3d 767 11th Cir. 1995) Successful TM claim and profits were

awarded to P. Insurance company was required to

indemnify D for all profits awarded to P. Justification: insurer knew terms of

Lanham Act when the policy was drafted.

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What Might not be Covered? Computer network liability Breach of security Crime and the Internet Errors and Omissions Intellectual property infringement

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Suggested Minimum for an e-Commerce Site

Libel Unauthorized access (security) Viruses Intellectual property infringement Web site failure - loss of data Product liability (if applicable) General liability (contractor is injured at

client site)

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Other Key Requirements Negligent acts Errors and Omissions Breach of duty Geographic scope: where is business

conducted, including internationally? What could go wrong and how much could

it cost?

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Internet Insurance is not Standardized

There is no boilerplate for online insurance - attorneys must be vigilant.

Every online business have different needs: Content provider Product reseller Service provider

Is the policy appropriate?

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General Liability Policies & I.P. Commercial general liability (CGL)

coverage policy (the most common): Advertising injury. “injury arising out of misappropriation of

advertising ideas or style of doing business,” or “infringement of copyright, title or slogan.”

Does this include online activities?

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General Liability (cont’d)

Few cases address the limits of advertising injury: P.J. Noyes v. American Motorists Ins. Co

(855 F. Supp. 492 D. N.H. 1994).

Insured used P’s TM in its own advertising. Insurer had a duty to defend and provide

coverage for claim of: Common law TM and unfair competition. False designation of origin and misrepresentation.

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Not all I.P. Claims are Covered American Economy Ins. Co. v. Reboans, Inc.

(852 F. Supp. 875 N.D. Cal. 1994; a minority opinion!)

Insured was sued for selling counterfeit products. Fed TM infringement, Fed counterfeiting, false

representations and designations of origin.

Court said misappropriation was not covered: a TM is not an advertising idea or style of doing business - copied products, not ads.

No reasonable expectation of coverage.

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Business Owner’s Liability Coverage

Advertising injury: “infringement of trademark, service mark, or trade name … in connection with goods, products, or services sold, offered for sale, or advertised by the insured.”

Parameter Drive Software Inc. v. Mass. Bay Ins. Co (25 F. 3d 336 6th Cir 1994): false designation of origin and unfair competition are

included in advertising injury.

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Reorganization/Bankruptcy

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Reorganizations Important to recognize when things are bad IRC 368

October 18, 2000

In Stable Condition

The latest earnings reports carry more weight for the Internet Economy than any that have come before. The markets are in disarray, and deep currents of uncertainty run through once-confident companies.

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Introduction to Bankruptcy Federal law (11 USC 101) designed to

give debtors a ‘fresh start.’ Article 1 (section 8 clause 4) of the

constitution gives Congress the authority to establish bankruptcy law.

Designed to fairly balance the interests of the overwhelmed debtor and the creditor(s).

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Key Forms of Bankruptcy Chapter 7: complete liquidation of assets and

discharge of (almost) all debts. Chapter 11: reorganization to extend and/or

reduce debt. Chapter 13: provides 36-60 months for

repayment of secured debts (and a percentage of unsecured debts). Not available for corporations. Must have a regular income.

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Most Failing e-Business Don’t Have Many Creditors 40 dot-coms went out of business in December,

2000. Total cost to investors: >$1,500,000,000. Only ten filed for bankruptcy. The rest paid their bills and closed their doors.

No bank loans. Few assets.

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After the Funding is Gone, What Remains?

Intellectual property: Trademarks; Domain names; Patented processes; or Trade secrets.

Customer lists (be careful about privacy issues).

Net operating loss. Lease & equipment. Liquidity if shares are public.

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Risks to 3rd Parties

No payment for products or services. Cancelled executory contracts

Scramble for alternative suppliers. No more product support or updates. Projects may be left incomplete. Assets or obligations tied up in bankruptcy

proceedings.

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Practical Hints Ensure the company’s cash burn rate is monitored and

understood. Use independent accounting/auditing services. Do a D&B or other search to assess the viability of a

third party before starting a business relationship. Consider the possibility of bankruptcy in any contract. Secure the assets in a transaction when appropriate

(Article 9). Establish an exit strategy when the business is first

formed – not when it is failing.

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Questions & Answers