covington & burling covington & burling 1998 business law for the netpreneur seminar...

COVINGTON & BURLINGCOVINGTON & BURLING

Covington & Burling 1998

Business Law For The Netpreneur Seminar

Covington & Burling

May 18, 1998

Business Law For The Netpreneur Seminar

Covington & Burling

May 18, 1998



CHOOSING THE FORM OF ENTITYCHOOSING THE FORM OF ENTITY

Bruce WilsonPartner

Covington & Burling



What Are the Seven Basic Choices? When Is It Time To Decide? What Matters in Deciding Which

Form?

What Are the Seven Basic Choices? When Is It Time To Decide? What Matters in Deciding Which

Form?

Choosing The Form Of Entity



What Are the Seven Basic Choices?– Sole Proprietorships -- A Fancy Name for

You– Corporations -- “S” and “C” Types– Partnerships -- Limited and General– Limited Liability Companies (“LLCs”)– Limited Liability Partnerships (“LLPs”)

What Are the Seven Basic Choices?– Sole Proprietorships -- A Fancy Name for

You– Corporations -- “S” and “C” Types– Partnerships -- Limited and General– Limited Liability Companies (“LLCs”)– Limited Liability Partnerships (“LLPs”)




When Is It Time to Decide?– The "Follow the Money" Rule:

• When There Are Multiple Owners/Investors

• When The Business Generates Revenues Or Assets

When Is It Time to Decide?– The "Follow the Money" Rule:

• When There Are Multiple Owners/Investors

• When The Business Generates Revenues Or Assets




What Matters in Deciding Which Form?– Who Owns (Or Will Own) the Business?

– What is the Nature of Each Owner's Interest?

– Who Manages (or Will Manage) the Business?

– How (and When) Will the Money Flow?

– "Personal Recourse" (Are You Putting Up The House)?

– What Happens on April 15?


– What is the Nature of Each Owner's Interest?

– Who Manages (or Will Manage) the Business?

– How (and When) Will the Money Flow?

– "Personal Recourse" (Are You Putting Up The House)?

– What Happens on April 15?





• One Individual

• A Few Individuals

• Lots of Owners

• Any Corporate Owners (Venture Funding)?

• The Same Group Over Time, Or Will Owners Vary (Transfers Among Owners)?


• One Individual

• A Few Individuals

• Lots of Owners

• Any Corporate Owners (Venture Funding)?

• The Same Group Over Time, Or Will Owners Vary (Transfers Among Owners)?




What Matters in Deciding Which Form?– What Is the Nature of Each Owner's

Interests?• “Common” Interests

• “Preferred” Interests

• “Carried” Interests

• “Convertible” Interests

What Matters in Deciding Which Form?– What Is the Nature of Each Owner's

Interests?• “Common” Interests

• “Preferred” Interests

• “Carried” Interests

• “Convertible” Interests




What Matters in Deciding Which Form?– Who Manages (or Will Manage) the

Business?• One Owner

• A Few Owners

• A Mix of Owners and Non-Owners

What Matters in Deciding Which Form?– Who Manages (or Will Manage) the

Business?• One Owner

• A Few Owners

• A Mix of Owners and Non-Owners




What Matters in Deciding Which Form?– How (and When) Will the Money Flow?

• Investment: Self, Angel, Venture, Private, Public

• Revenues: When in Your Business Plan?

• Expenses: How Fast and How Deep?

What Matters in Deciding Which Form?– How (and When) Will the Money Flow?

• Investment: Self, Angel, Venture, Private, Public

• Revenues: When in Your Business Plan?

• Expenses: How Fast and How Deep?




What Matters in Deciding Which Form? – "Personal Recourse” Are You Putting Up

The House? • Limited Liability is Commonly a Misnomer

What Matters in Deciding Which Form? – "Personal Recourse” Are You Putting Up

The House? • Limited Liability is Commonly a Misnomer




What happens on April 15? What happens on April 15?




TAX TREATMENTOF ENTITIES

TAX TREATMENTOF ENTITIES

Robert ShawOf Counsel

Covington & Burling



Tax Treatment of Entities

Corporations– State-law Corporations (other than

S Corporations)– Foreign entities on "Corporation List"– Entities that "elect" corporate tax status

(including partnerships and LLC's)

Corporations– State-law Corporations (other than

S Corporations)– Foreign entities on "Corporation List"– Entities that "elect" corporate tax status

(including partnerships and LLC's)



S Corporations– Corporations That Are Eligible For, and

Elect, "Subchapter S" Status– Eligibility requirements include:

• 75 or fewer shareholders

• Shareholders must be individuals (other than non-resident aliens), estates or certain trusts or tax exempt organizations

• Only one class of stock

S Corporations– Corporations That Are Eligible For, and

Elect, "Subchapter S" Status– Eligibility requirements include:

• 75 or fewer shareholders

• Shareholders must be individuals (other than non-resident aliens), estates or certain trusts or tax exempt organizations

• Only one class of stock




Partnerships– Domestic partnerships and LLC’s (with at

least 2 members) – Other non-corporate entities with at least 2

members that "elect" partnership tax status

Partnerships– Domestic partnerships and LLC’s (with at

least 2 members) – Other non-corporate entities with at least 2

members that "elect" partnership tax status




Layers Of Tax– Corporations: Double layer of Federal

and State income tax • Net income generally taxed to corporation at

corporate rates (currently up to 35% )

• Distributions generally taxable to shareholders

Layers Of Tax– Corporations: Double layer of Federal

and State income tax • Net income generally taxed to corporation at

corporate rates (currently up to 35% )

• Distributions generally taxable to shareholders





Layers of Tax– S Corporations: Single layer of Federal

and State income tax (except for "C" corporation gain and certain States, including DC)

• S Corporation not subject to tax

• Net income taxed pro rata to shareholders (whether or not distributed)

• Stock basis increased by net income to allow tax-free distributions

Layers of Tax– S Corporations: Single layer of Federal

and State income tax (except for "C" corporation gain and certain States, including DC)

• S Corporation not subject to tax

• Net income taxed pro rata to shareholders (whether or not distributed)

• Stock basis increased by net income to allow tax-free distributions




Layers of Tax – Partnerships: Single layer of Federal and

State income tax • Partnership not subject to tax

• Net income taxed to partners (whether or not distributed)

• Partners can choose any sharing ratio that has “substantial economic effect”

• Basis in partnership increased by net income to allow tax-free distributions

Layers of Tax – Partnerships: Single layer of Federal and

State income tax • Partnership not subject to tax

• Net income taxed to partners (whether or not distributed)

• Partners can choose any sharing ratio that has “substantial economic effect”

• Basis in partnership increased by net income to allow tax-free distributions



Distributions of Cash– Corporations: Taxable as dividends (to

extent of earnings and profits), then as nontaxable return of capital (to extent of basis in stock), and then as capital gain

– S Corporations: Taxable only if exceeds basis in stock

– Partnerships: Taxable only if exceeds basis in partnership interest

Distributions of Cash– Corporations: Taxable as dividends (to

extent of earnings and profits), then as nontaxable return of capital (to extent of basis in stock), and then as capital gain

– S Corporations: Taxable only if exceeds basis in stock

– Partnerships: Taxable only if exceeds basis in partnership interest




Complexity– Corporations: Least complicated, easiest

to take "public"– S Corporations: Ownership restrictions

and only a single class of stock allowed– Partnerships: Most complex, substantial

tax "boilerplate,” difficult to take “public”

Complexity– Corporations: Least complicated, easiest

to take "public"– S Corporations: Ownership restrictions

and only a single class of stock allowed– Partnerships: Most complex, substantial

tax "boilerplate,” difficult to take “public”




Flexibility– Corporations: Flexible employee incentives.

Flexibility on classes of shares, reorganization, etc.

– S Corporations: All distributions and tax items must be shared pro-rata. Limited flexibility on employee incentives and reorganizations

– Partnerships: Greatest flexibility making distributions and allocating tax items. Limited flexibility on employee incentives

Flexibility– Corporations: Flexible employee incentives.

Flexibility on classes of shares, reorganization, etc.

– S Corporations: All distributions and tax items must be shared pro-rata. Limited flexibility on employee incentives and reorganizations

– Partnerships: Greatest flexibility making distributions and allocating tax items. Limited flexibility on employee incentives




Summary of Corporations– Double layer of federal and state income tax– Cash distributions taxable as dividends to the

extent of earnings and profits, then as nontaxable return of capital to the extent of basis in stock, and then as capital gain

– Least complicated, easiest to take "public"

– Flexible employee incentives

– Flexibility on classes of shares, reorganization, etc.

Summary of Corporations– Double layer of federal and state income tax– Cash distributions taxable as dividends to the

extent of earnings and profits, then as nontaxable return of capital to the extent of basis in stock, and then as capital gain

– Least complicated, easiest to take "public"

– Flexible employee incentives

– Flexibility on classes of shares, reorganization, etc.




Summary of Corporations – Other Issues

• Pre-contribution gain subject to two levels of tax

• Distribution of appreciated property triggers two levels of tax

• Losses can only be used at the corporate level

Summary of Corporations – Other Issues

• Pre-contribution gain subject to two levels of tax

• Distribution of appreciated property triggers two levels of tax

• Losses can only be used at the corporate level




Summary of S Corporations– Single level of federal income tax (except for

"C" corporation gain)

– States differ on whether subject to single (VA, MD) or double (DC) layer of tax

– Cash distributions taxable only if exceed basis in stock

– Eligibility rules include ownership restrictions and only a single class of stock allowed

Summary of S Corporations– Single level of federal income tax (except for

"C" corporation gain)

– States differ on whether subject to single (VA, MD) or double (DC) layer of tax

– Cash distributions taxable only if exceed basis in stock

– Eligibility rules include ownership restrictions and only a single class of stock allowed




Summary of S Corporations – All distributions and tax items must be shared pro-

rata– Limited flexibility on employee incentives and

reorganizations– Other Issues:

• Pre-contribution gain on appreciated property allocated pro-rata (shifts possible)

• Distribution of appreciated property triggers single level of tax

• Losses limited to tax basis in stock plus amounts loaned to the S Corporation

Summary of S Corporations – All distributions and tax items must be shared pro-

rata– Limited flexibility on employee incentives and

reorganizations– Other Issues:

• Pre-contribution gain on appreciated property allocated pro-rata (shifts possible)

• Distribution of appreciated property triggers single level of tax

• Losses limited to tax basis in stock plus amounts loaned to the S Corporation




Summary of Partnerships– Single layer of federal and state income tax

– Cash distributions taxable only if exceed basis in partnership interest

– Most complex -- substantial tax "boilerplate"

– Greatest flexibility making distributions and allocating tax items

– Limited flexibility on employee incentives (profits interest)

Summary of Partnerships– Single layer of federal and state income tax

– Cash distributions taxable only if exceed basis in partnership interest

– Most complex -- substantial tax "boilerplate"

– Greatest flexibility making distributions and allocating tax items

– Limited flexibility on employee incentives (profits interest)




Summary of Partnerships – Other Issues:

• Pre-contribution gain on appreciated property taxed back to contributing partner

• Generally, appreciated property can be distributed without triggering gain

• Losses limited to tax basis in partnership interest plus partner's share of all of the partnership's liabilities (generally: recourse liabilities shared by economic risk of loss; nonrecourse liabilities shared by profits interest and partner loans only to loaning partners)

Summary of Partnerships – Other Issues:

• Pre-contribution gain on appreciated property taxed back to contributing partner

• Generally, appreciated property can be distributed without triggering gain

• Losses limited to tax basis in partnership interest plus partner's share of all of the partnership's liabilities (generally: recourse liabilities shared by economic risk of loss; nonrecourse liabilities shared by profits interest and partner loans only to loaning partners)




CORPORATE GOVERNANCE

Techniques for Predictable Sharing of Control

CORPORATE GOVERNANCE

Techniques for Predictable Sharing of Control

W. Andrew JackOf Counsel

Covington & Burling



Corporate Governance --Techniques for Predictable Sharing of Control

Situations that raise control issues – Start-up (“prenup” for the co-founders)

– Entrepreneur with employee shareholders (avoiding mutiny)

– Outside financing (giving the venture capitalists a voice)

– Estate planning (shifting equity, but not control, to the next generation)

Situations that raise control issues – Start-up (“prenup” for the co-founders)

– Entrepreneur with employee shareholders (avoiding mutiny)

– Outside financing (giving the venture capitalists a voice)

– Estate planning (shifting equity, but not control, to the next generation)



Corporate Governance -- Techniques for Predictable Sharing of Control

Mechanisms to Address Control Issues– Shareholder Agreements– Voting Trusts– "Irrevocable" Proxies– Articles of Incorporation provisions– Bylaws provisions

Mechanisms to Address Control Issues– Shareholder Agreements– Voting Trusts– "Irrevocable" Proxies– Articles of Incorporation provisions– Bylaws provisions




Control Issues for Decision– Election of Directors

• Board size

• Board composition

– Ground Rules for Major Company Decisions• Sale of substantially all assets or merger

• Amendment of Articles or Bylaws

– Issuance of Additional Shares• Preemptive rights/antidilution protection

Control Issues for Decision– Election of Directors

• Board size

• Board composition

– Ground Rules for Major Company Decisions• Sale of substantially all assets or merger

• Amendment of Articles or Bylaws

– Issuance of Additional Shares• Preemptive rights/antidilution protection




Control Issues for Decision– Share Transfer Restrictions

• Company call rights

• Company rights of first refusal

• Shareholder rights of first refusal

• Sale participation rights (i.e. "tag along" and "drag along" rights)

– Resolution of Deadlocks

Control Issues for Decision– Share Transfer Restrictions

• Company call rights

• Company rights of first refusal

• Shareholder rights of first refusal

• Sale participation rights (i.e. "tag along" and "drag along" rights)

– Resolution of Deadlocks



STOCK COMPENSATION FOR THE

NETPRENEURAmy N. Moore

PartnerCovington & Burling

STOCK COMPENSATION FOR THE

NETPRENEURAmy N. Moore

PartnerCovington & Burling



Stock Compensation

Why Use Stock Compensation?– Stock is plentiful; cash is scarce– Gives employees a stake in the success of

the business– Favorable accounting treatment– Favorable tax treatment

• Flexible timing

• Lower tax rates

Why Use Stock Compensation?– Stock is plentiful; cash is scarce– Gives employees a stake in the success of

the business– Favorable accounting treatment– Favorable tax treatment

• Flexible timing

• Lower tax rates



Stock Compensation

What's On The Menu?

– Nonqualified Stock Options

– Incentive StockOptions

– Discounted StockOptions

What's On The Menu?

– Nonqualified Stock Options

– Incentive StockOptions

– Discounted StockOptions

– Stock Appreciation Rights

– Restricted Stock

– Phantom Stock

– Stock Purchase Plans

– ESOPs



Stock Compensation

How Do You Get The Best Tax Results?– Incentive stock options (ISOs)

• No tax at grant

• No tax at exercise

• Capital gain tax at sale of stock

How Do You Get The Best Tax Results?– Incentive stock options (ISOs)

• No tax at grant

• No tax at exercise

• Capital gain tax at sale of stock– 28% if you hold stock 12 months

– 20% if you hold stock 18 months

– 18% (after 2000) if you hold stock 5 years



– 18% (after 2000) if you hold stock 5 years



Stock Compensation

What Are The Drawbacks Of ISOs?– Vesting limited to $100,000 per year– 10% shareholders must pay 110% of market value– Must hold stock two years from grant, one year from exercise– Shareholders must approve plan– Employer gets no deduction– Employee might owe alternative minimum tax (AMT)– Available only to employees

What Are The Drawbacks Of ISOs?– Vesting limited to $100,000 per year– 10% shareholders must pay 110% of market value– Must hold stock two years from grant, one year from exercise– Shareholders must approve plan– Employer gets no deduction– Employee might owe alternative minimum tax (AMT)– Available only to employees



Stock Compensation

Is There A Less Restrictive Alternative?– Nonqualified stock options

• No grant limits or holding periods

• No tax at grant; no AMT

• Ordinary income tax and FICA tax at exercise

Is There A Less Restrictive Alternative?– Nonqualified stock options

• No grant limits or holding periods

• No tax at grant; no AMT

• Ordinary income tax and FICA tax at exercise– Maximum income tax rate is 39.6%

– FICA tax rate is 7.65% (1.45% above wage base)

• Capital gain tax at sale of stock



Stock Compensation

How Do You Exercise An Option Without Cash?– Stock appreciation rights– Pyramiding– Stock-for-stock exercise– Reload options– Cashless exercise– Discounted options

How Do You Exercise An Option Without Cash?– Stock appreciation rights– Pyramiding– Stock-for-stock exercise– Reload options– Cashless exercise– Discounted options



Stock Compensation

How Do You Retain and Motivate Key Employees?– Options that expire at termination of

employment

– Options that vest• After a given number of years, or

• When performance targets are reached

– Restricted stock

How Do You Retain and Motivate Key Employees?– Options that expire at termination of

employment

– Options that vest• After a given number of years, or

• When performance targets are reached

– Restricted stock



Stock Compensation

What If You Expect A Sharp Rise In Stock Price?– Vested options

• Exercise immediately

– Restricted stock• Make § 83(b) election

What If You Expect A Sharp Rise In Stock Price?– Vested options

• Exercise immediately

– Restricted stock• Make § 83(b) election



Stock Compensation

What If Stock Is Closely Held?– Phantom stock or performance units

What If Stock Is Closely Held?– Phantom stock or performance units

• S Corporation (shareholder limit)• Single-member LLC• Non-stock entities

• S Corporation (shareholder limit)• Single-member LLC• Non-stock entities• Valuation issues• Valuation issues



Stock Compensation

Are There Broad-based Stock Compensation Plans?– Employee Stock Purchase Plans

• Tax treatment similar to ISOs

• Must cover all employees

– Employee Stock Ownership Plans (ESOPs)• Tax-qualified retirement plans

• Permit tax-advantaged borrowing

• Provide tax benefits for large shareholders– Tax-deferred rollover

– Estate planning opportunities

Are There Broad-based Stock Compensation Plans?– Employee Stock Purchase Plans

• Tax treatment similar to ISOs

• Must cover all employees

– Employee Stock Ownership Plans (ESOPs)• Tax-qualified retirement plans

• Permit tax-advantaged borrowing

• Provide tax benefits for large shareholders– Tax-deferred rollover

– Estate planning opportunities



Stock Compensation

What Other Pitfalls Should You Know About?

What Other Pitfalls Should You Know About?– Corporate governance issues– Securities law issues– Going-public issues– Accounting issues

– Corporate governance issues– Securities law issues– Going-public issues– Accounting issues

– Going-public issues– Going-public issues



TRADEMARK AND COPYRIGHT ISSUES FOR NEW COMPANIES

TRADEMARK AND COPYRIGHT ISSUES FOR NEW COMPANIESKathleen Gallagher-Duff

AssociateCovington & Burling



Trademark Law

What Is A Trademark?– Basic Purpose Is To Prevent Confusion– Selection of a Trademark or Company

Name• Protection depends on distinctiveness

• Generic, descriptive, suggestive,arbitrary, fanciful

What Is A Trademark?– Basic Purpose Is To Prevent Confusion– Selection of a Trademark or Company

Name• Protection depends on distinctiveness

• Generic, descriptive, suggestive,arbitrary, fanciful



Trademark Law

Trademark Law Clearance – Why?

• Protect against use of marks that violate other users' trademark rights

• Avoid litigation

– Clearance Steps• Preliminary Screening Search

• Full Trademark Search

• Discussion of Other Marks in Industry

Trademark Law Clearance – Why?

• Protect against use of marks that violate other users' trademark rights

• Avoid litigation

– Clearance Steps• Preliminary Screening Search

• Full Trademark Search

• Discussion of Other Marks in Industry



Trademark Law

Steps to Protect Your Marks– Federal Registration– Use of Trademark Symbols

• TM and SM

– ® (Federal Registration Symbol)– Monitoring Others' Use of Similar Marks– Domain Names

Steps to Protect Your Marks– Federal Registration– Use of Trademark Symbols

• TM and SM

– ® (Federal Registration Symbol)– Monitoring Others' Use of Similar Marks– Domain Names



Copyright Law

Copyright– Protects original expression– Rights held by copyright owners

• Right to make copies

• Right to distribute

• Right to display publicly

• Others

Copyright– Protects original expression– Rights held by copyright owners

• Right to make copies

• Right to distribute

• Right to display publicly

• Others



Copyright Law

Copyright Issues Involving Web Sites– Determine ownership of web page design (designed

by employee or by outside contractor with express"work for hire" provisions?)

– Before posting any written, graphic, audio or visual material on your web site, determine whether you are the author, for copyright purposes, of the material.

– Is the material in the "public domain"?

Copyright Issues Involving Web Sites– Determine ownership of web page design (designed

by employee or by outside contractor with express"work for hire" provisions?)

– Before posting any written, graphic, audio or visual material on your web site, determine whether you are the author, for copyright purposes, of the material.

– Is the material in the "public domain"?



Copyright Law

Copyright Issues Involving Web Sites – Secure a transfer from copyright holder transferring right

publicly to display, reproduce, distribute and transmit the work electronically on the Internet.

– Secure right to create an adaptation or "derivative" work.

– Obtain warranties and other protections for protection against possible infringement.

– Copyright notice.

Copyright Issues Involving Web Sites – Secure a transfer from copyright holder transferring right

publicly to display, reproduce, distribute and transmit the work electronically on the Internet.

– Secure right to create an adaptation or "derivative" work.

– Obtain warranties and other protections for protection against possible infringement.

– Copyright notice.



EMPLOYMENT AGREEMENTS EMPLOYMENT AGREEMENTS

Jeffrey HuvellePartner

Covington & Burling



Overview– Your employment objectives

• What you need to accomplish

• What you need to avoid

– The basic principle• Fairness

• Demonstrating fairness

Overview– Your employment objectives

• What you need to accomplish

• What you need to avoid

– The basic principle• Fairness

• Demonstrating fairness

Employment



Employment

Written Agreements– The at-will rule

• No fixed term

• At any time for any reason or no reason

– Written employment agreements• Term (length) of employment

• Grounds for separation

• Severance

Written Agreements– The at-will rule

• No fixed term

• At any time for any reason or no reason

– Written employment agreements• Term (length) of employment

• Grounds for separation

• Severance



Employment

Confidential Information– Confidentiality obligations

• Trade secrets, customer lists, confidential business strategy– But not general skill, knowledge and experience

• Common law fiduciary duty

• Written agreements

• Practical realities of enforcement

Confidential Information– Confidentiality obligations

• Trade secrets, customer lists, confidential business strategy– But not general skill, knowledge and experience

• Common law fiduciary duty

• Written agreements

• Practical realities of enforcement



Employment

Restrictions on Employee Mobility – Non-compete agreements

• A restraint on trade

– Common law vs. statutory requirements– Consideration– Reasonableness

• No greater than necessary for employer• Not unduly harsh to employee• Not contrary to public interest

Restrictions on Employee Mobility – Non-compete agreements

• A restraint on trade

– Common law vs. statutory requirements– Consideration– Reasonableness

• No greater than necessary for employer• Not unduly harsh to employee• Not contrary to public interest



Employment

Restrictions on Employee Mobility– Restrictions

• Scope Of Activity

• Time

• Geography

– Enforcement• Injunction

• Damages

Restrictions on Employee Mobility– Restrictions

• Scope Of Activity

• Time

• Geography

– Enforcement• Injunction

• Damages

covington & burling covington & burling 1998 business law for the netpreneur seminar...

Documents

owners interests

mix of owners

business law

common interests

basic choices

money rule

money flow

c types partnerships