S corp or C corp? Decisions pile up when creating a startup

If you haven’t been downtown recently, you might think you are in another city. Emerging from the shadows of the major Rochester corporations of yesteryear is a flurry of startup businesses. One need only have headed downtown in the past month for the Innovative Solutions Tech Conference and the Light and Sound Interactive Conference and Expo to believe “the times they are a changin’” with technologically advanced entrepreneurs leading the way. Indeed, the innovation zone being developed downtown and its business incubators are specifically designed to foster startup business and new technologies. From one loyal Rochesterian to another, we can only hope that the entrepreneurs of today will achieve the success of their local primogenitors.

As legal counsel for startups and venture funds, we have seen our share of entrepreneurial remorse. An understanding of the pertinent legal landscape, however, can help avoid distractions and save heartache when further down the startup continuum. To assist, here are some key “heads-ups for startups”:

Select the right type of entity

One initial question asked is, “What type of legal entity should be formed for the business?” While they might not require significant legal documentation, fees or governmental filings, sole proprietorships and general partnerships should be avoided. These entities do not provide any protections for the founder(s) against creditors of the business, and permit vendors, contracting parties or injured persons to sue the founder and recover against the founder’s personal assets (e.g., home, car, life savings). As such, corporations and limited liability companies (LLCs) are the prudent forms for startup entities. Both are formed through state filings and are more expensive to form and operate due to legal, tax and accounting issues, but offer significant advantages for founders (and follow-on investors) including liability protections from creditors, tax savings through deductions and treatments, and facilitating the capital raising process.

A corporation can be formed as a C corporation or S corporation. An S corporation and LLCs provide favorable tax treatment, as taxable income passes through the entity to equity holders, when compared to a C corporation, where income is taxed at both the entity and equity holder levels. There are limitations on the types and number of investors with an LLC and S corp, including a prohibition on entities being investors in an S corporation. While an S corp and LLC may be converted into a C corp, doing so has significant tax implications and requires significant professional advisor expenses. As such, most venture capital-backed companies are C corps.

Regardless of the form of entity, it is imperative that the formation documents or a founder’s agreement clearly commemorates the founders’ understanding, including with respect to ownership allocation, decision making, transfers of equity, and death and disability implications. Think of it as a prenuptial agreement for the startup—while the best of friends today, the agreement only becomes very important after it is needed.

Choose your name wisely

When choosing a company name, due diligence can avoid future trademark infringement and domain name conflicts. Trademark infringement can occur when the use of a mark is likely to cause confusion among consumers as to the source of a good or service. Conduct the following searches to avoid these issues:

n  Internet search engines to find companies using the same name;

n  The corporate and LLC databases from the secretary of state’s website for similar company names;

n  Domain search of an internet registrar, such as NetworkSolutions.com, to see if a pertinent domain name is available; and

n  The U.S. Patent and Trademark Office website for federal trademark registrations of your contemplated name.

While these searches are helpful, they are not dispositive. An intellectual property attorney or specialized search firm can conduct a more thorough search and add essential benefits through skilled assessments of the likelihood of confusion and navigation of the intricacies of applicable law, including phonetic equivalents and international implications.

People often don’t realize that the successful formation of an entity within a state only reserves the entity’s name from use by others within such state. Generally speaking, a company with the same name can be formed in any other state but the formation state. For greater protection, national or international registration of the company’s name should be sought.

I have had many clients enamored with a specific company name only to subsequently find it is already in use or registered. While those new koozies might need to be reordered, it will never be easier to change a company or product name than it will be in the first phase of the business life cycle.

Don’t ignore securities laws

If you form a corporation or LLC, the shares of stock or membership interests sold to founders and later to investors are securities subject to federal and state (known as blue sky) securities laws. These laws require that any offer or sale of a security (including to friends, family and angel investors) comply with specific disclosure and filing requirements unless an exemption is available.

A failure to comply with these requirements can have dire consequences: criminal and civil penalties for both the founders and company, including the purchase back from investors of securities at the original issuance price rather than the lower current market value. While it is not uncommon for investors to insist on the use of form documents such as those available from the National Venture Capital Association, a securities lawyer is required to prepare the offering memorandum, make applicable filings with the SEC and state securities administrators, and to represent the interests of the company and founder in negotiating these pro-investor forms.

Protect your intellectual property

The core asset of any technology-based startup is its underlying intellectual property, or IP. Entrepreneurs should become familiar with patents, copyrights, trademarks and trade secrets to recognize them and seek proper protection and monetization with legal counsel assistance. Delays in protection can result in forfeited rights, and the improper granting of joint or exclusive rights can limit the income potential and use by the startup.

Generally, an independent contractor will own IP created when performing services without a written agreement assigning it to the company requesting the services. A common misunderstanding is that a “work made for hire” provision in an agreement establishes such assignment. In reality, a mere statement that the services are a “work made for hire” does not accomplish such assignment because a “work made for hire” is a concept limited to specific categories of copyright law (and no other IP). As such, it is imperative that every startup company diligently uses properly drafted proprietary rights and assignment agreements/provisions with all independent contractors and employees. Express confidentiality obligations should be established for matters not subject to traditional IP protections.

Google is not a law firm

As the former general counsel of a leading media company in the dot.com glory days, I am a huge proponent of using the internet to assist with the simplest of tasks in everyday life. While the staunchest lawyer must admit the internet is a wonderful contract repository, the use of such agreements is fraught with risk where the underlying business deal and legal principles are not fully understood. This can result in being contractually bound to unanticipated terms and costly litigation over conflicting concepts or onerous liabilities.

Seek out the right advisers

As a final note, it is imperative that entrepreneurs seek out the assistance of advisers who are not only skilled in their profession but also possess proven track records of dealing with the trials and tribulations of startup organizations. The wisdom these advisers have gained through experience can assist with avoiding the same pitfalls. A common theme among the accolades expressed by the most successful of entrepreneurs is their paths to success were cleared by surrounding themselves with “smart” people.

Jeremy J. Wolk is a partner in Nixon Peabody LLP’s Business & Finance department.