birthing unicorns: a practical guide to legal aspects of launching digital media startups

Pillsbury Winthrop Shaw Pittman LLP

Birthing Unicorns:A Practical Guide to Legal Aspects of Launching Digital Media Startups

Ron FlemingPartner, Head of Emerging CompaniesPillsbury Winthrop Shaw Pittman LLP

December 8, 2015

Defining Success

The “Shiny Red Apple” approach Implement legal and financial structures that do not impede your

ability to raise capital in a timely and expedient fashion, grow the business or execute a sale or IPO process

Optimize for attracting capital and talent and facilitating liquidity Key questions--What is company’s timeline? Capital needs? Plans to

issue equity to employees and other advisors? Allow potential investors/acquirers to focus on the merits of the

business and the quality of the team, and not be distracted by background noise

2 | Birthing Unicorns: A Practical Guide to the Legal Aspects of Launching Digital Media Startups

Being Opportunistic

Most M&A exits of digital media companies do not result from an orchestrated, investment-banked process, but instead opportunistically arise

The bonanza deals are virtually always companies that are “bought, not sold”

Buyers approach, and transactions can happen fast (sometimes as quickly as a few weeks)


Choose the Right Co-Founder

--Carefully select co-founder the way one picks any partner—be highly discerning--Enter into equity vesting arrangements to ensure that co-founder forfeits equity if leaves prior to the fourth anniversary of joining team--Only an “at will” employment offer letter Carefully limit board rights, other governance provisions


Chose the Right Form of Entity

As a general rule, digital media companies should be organized as a Delaware “C” corporation if the plan is to raise institutional funding in next 12 months

LLCs are becoming more commonplace, particularly if no near-term plans to raise capital. Note that many VCs can’t or won’t invest in LLCs, and will condition investments on conversion to C-corp

LLCs have complexities involving options, K-1 reporting, etc. that generally make them less than ideal vehicles for media/tech high growth company

Ambiguous case law, poorly drafted statutes and the lack of IRS guidance, practitioners are often on their own to determine the tax consequences of compensatory partnership options


Trials and Travails of the Wrong Entity Type

Consider drawbacks to using S-corp structures including major diligence process by acquirer/investors seeking to ensure compliance with numerous technical requirements

Catastrophic if S--corp characterization fails – end up with taxable income in corporation. Note that 338(h)(10) election fails if you have a bad S, so intense scrutiny

Examples of technical requirements we see: Ineligible stockholders - LLC that is treated as partnership because more

than one holder, so not disregarded Non-proportional distributions to stockholders Loans to stockholders that aren’t documented as loans, shareholder using

the company as a checkbook


Set up In the Right Location

Delaware, Delaware, Delaware…If in doubt, Delaware is the right locale for organization. It’s virtually malpractice to incorporate in New York-- NY and NY alone has a very

entrepreneur/investor unfriendly provision --Section 630(a) of the New York Business Corporation Law (applicable only to privately held corporations, not to LLCs or investment companies) renders the ten largest shareholders personally liable for employee compensation

It covers not just wages and salaries, but other types of monetary compensation as well, including overtime, vacation, severance pay, contributions to insurance or welfare benefits, pension or annuity funds.

The stockholders are liable jointly and severally. This means that the employees can choose to go after one stockholder for the whole amount instead of all ten. The law allows that shareholder to seek pro rata contributions from the other largest stockholders.


Get Your House in Order

Anticipate the diligence process for various capital raising, strategic or liquidity transactions by keeping an updated virtual dataroom – you need it for venture financings, exits, your audit and your IPO


Get Your House in Order (cont’d)

Be prepared: Audited Financials Capitalization – make sure cap table is clean and correct Clean corporate governance (board minutes/stockholder actions) 409A – make sure equity grants been done properly and well IP - does your company own it? Make sure all employees signed up

proprietary info agreements Salaries to employees - withheld/liability to directors


Aggressively deal with potential litigation

Deal with nasty grams from competitors related to IP

Address allegations that you poached confidential info/solicited employees etc.

Obtain releases from terminated employees


Corporate Controls

Implement a system of good/clean controls and systems

Hire known national or regional auditors Experienced finance staff including a CFO with

transactional background Having financial statements prepared in

accordance with GAAP


Clean Capitalization

Control your equity issuances Get equity issued “early” when fmv is low Ensure compliance with IRC Section 409A Get independent 409A valuations on a periodic basis once

you are an established company, and tie granting thereto Have one person in charge of capitalization table even if its

outside accountants or lawyers Do not issue warrants or other documents promising equity

as an evergreen percentage, but rather a fixed number of shares

Ensure warrants terminate on an exit?


Protect your IP

Patents and trademarks – make sure filings are in order Assignment of inventions – all employees, consultants,

contractors, make sure company owns what he it believes it owns

Confidentiality agreements Trade secrets Domain names


Sales Tax

There is no greater hot button issue than compliance with the ever changing quagmire of state sales tax rules Trying to assert nexis over internet sales and SAAS,

very aggressive re: taxing a provider based on the presence of a user and saying that provider is present in state or locality because user in state has downloaded software or used SAAS

If you offer service on the net, have to make sure managed sales and use tax exposure properly


Employment Law Compliance

Properly classify exempt vs. non-exempt, employee vs. contractor

Evaluate compliance with the overtime rules under federal and state law

What does your offer letter say? Confirm severance/release agreement up to date


Prudent Contracting

Do your key customer/supplier (e.g., licenses) contracts have change of control/anti-assignment provisions that will be triggered by a sale?

Are there any funky provisions that will slow you down, e.g., many strategics ask for rights of first or last refusal/rights of first negotiation, etc., are you burdened by any of those?

Are you party to long term agreements that have unusual risk? Any odd non-compete provisions? Any long-term contracts that will burden the business, e.g., long

term lease that will prevent integration? Does your investment banking letter have a tail or entitle bank to

special rights?


Securities Law Compliance

Make sure you have valid securities law exemptions for all equity issuances

Were Reg D and Blue Sky filings completed? Are your investors accredited? Have you gotten a primer on the new 506 Rules?


Related Party Transactions

Make sure you’ve used good corporate governance when dealing with related party transactions

KISS principle applies—avoid complex structures, e.g,. the founding team retaining IP and licensing to company


Regulatory Issues

Proactively attack regulatory issues (e.g., escheat laws, gift cards)

Deal with privacy landscapes here and internationally—think Global


Keeping the Band Together

Most investment or M&A transactions are conditioned on keeping team in place

Consider impact of single/double trigger change of control provisions, including severance/acceleration

Design equity incentive plans to promote retention post-closing


JOBS Act Impact

Two key features of the Jumpstart Our Business Startups Act: General solicitation in Rule 506 offerings— Increased thresholds at which an issuer will be required to register

a class of securities under the Securities Exchange Act of 1934 (the “1934 Act”)

When combined with certain advantages already enjoyed by issuers in Rule 506 offerings, opens up an entirely new category of "publicly offered private offerings" that are largely exempt from substantive regulation at either the federal or state level, by issuers that will be able to avoid becoming public companies, for practical purposes, as long as they wish.


THE END GAME

Be prepared to facilitate being opportunistic Keep your corporate and contractual records

clean and ready for prime time Avoid burdensome contractual terms that affect

the biz or the process Design equity plans and comp structures to keep

team incented to remain


birthing unicorns: a practical guide to legal aspects of launching digital media startups

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